Well, now we know: monetary policy certainly isn’t rocket science.
James Saft
Reuters Columnist
Asked on Thursday if he was confident before implementing quantitative easing that it would work, outgoing Federal Reserve Chairman Ben Bernanke quipped:
“The problem with QE is that it works in practice, but it doesn’t work in theory.”
Seriously, imagine a NASA official after a moon shot joking that the booster rockets had worked in practice but not in theory. Think of the looks he might get from the astronauts standing alongside him.
Now, of course, Bernanke should be permitted one joke per four-year term, and he did go on to say that the Fed’s use of QE was grounded in practical experience from Japan and elsewhere as well as theoretical underpinnings from academia.
Still.
After years of the Fed engaging massively in QE, consensus about its effects is far stronger in terms of its effect on financial markets, where it is viewed as an electronic form of Viagra, than on the actual economy.
Bernanke went on to say that most research on asset purchases has suggested that “while there are differences in views about how effective QE is, the great majority of studies have found that (rounds of QE) are at least somewhat effective”.
“At least somewhat effective”. Not what you want on your tombstone, though for many of us it is no more than the truth.
Bernanke’s joke was referring, in part, to a paper delivered at the same meeting by his colleague from the San Francisco Fed, John Williams, which opened by quoting the old joke that “An economist is a man who, when he finds something works in practice, wonders if it works in theory.”
Much depends on your definition of “practice”, “theory” and “works”, especially the last.
Theory and practice
As Williams explains, there are two basic theories as to the mechanism through which QE should, in theory, work.
The first broad idea posits that financial markets are frictionless (i.e. populated by profit-maximizing robots), and that therefore QE won’t have an impact on asset prices, inflation or output, but merely serves as a kind of semaphore through which the central bank can signal its longer-term intentions about interest rates. For those of you willing to entertain the idea of a frictionless financial market, I refer you to the Facebook IPO, or if you must, to any bar at about 11 PM on a Thursday near any large financial exchange. ’Nuff said.
The second idea, acknowledging that financial markets are populated by people with conflicting interpretations of their own best interest, supposes that QE drives asset prices higher by forcing investors in safer assets out of their usual habitats.
“Two themes emerge from this research on the effects of asset purchases on asset prices. First, although individual estimates differ, this analysis consistently finds that asset purchases have sizeable effects on yields on longer-term securities,” Williams writes.
“Second, there remains a great deal of uncertainty about the magnitude of these effects and their impact on the overall economy.”
First, the easy part. Yes, QE drives financial markets. Williams reviews 15 studies and finds that the central tendency, or consensus, is that US$600bn of asset purchases lowers the yield on 10-year Treasury notes by 15 to 25 basis points.
That is significant, and indeed consensus is that QE has had a generally positive effect on financial assets. It is also safe to say that, as a direct effect of QE, this asset price inflation has directly benefited financial intermediaries, a segment of the economy which is arguably overgrown anyway.
Also, because the rich tend to own financial assets and others tend not to, QE generally fuelled wealth inequality.
Now, as to that real economy. One study found that QE2, the US$600bn program launched in 2011, shaved a quarter of a percentage point off of unemployment. Another is less optimistic.
What does seem clear is that if QE is having an impact it is doing so through the wealth effect, as people spend part of their stock market gains, rather than by encouraging investment, which remains low compared to corporate profitability.
So, what does all this mean now that QE is being withdrawn?
In some ways the implications are comforting. If QE didn’t help the economy all that much, perhaps QE going away won’t hurt all that much.
Unless you own financial assets. Then you are looking at a withdrawal of a support at a time when inflation is seemingly intractably low and the economy, all these years later, not really thriving.
Easy come, easy go.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)