Fed`s QE2: Miracle cure or moral hazard?

Updated: May 23, 2011, 19:02 PM IST

New York: When judging the Federal Reserve`s unprecedented monetary policies of the past few years, where you stand depends on where you sit.

There`s no doubt markets have responded. US stocks are up 28 percent since August 26, 2010, the day before Fed Chairman Ben Bernanke hinted the US central bank would fire up its money-printing press for a second round of economic aid, known as "QE2."

The gain amounts to USD 3.6 trillion in market capitalisation, and for a programme that consisted of USD 600 billion in Treasury purchases, that`s quite a multiplier -- and it doesn`t even count big gains in commodities and world stocks.

So far, so good -- for Wall Street. But ordinary savers who don`t measure their wealth in stocks have less to smile about. All that free money, designed to hold down interest rates and spur growth, also pushed up food and fuel prices, and consumers from Queens to Cairo have felt the pinch.

"If your definition of success is creating large capital gains for fund managers in the stock market, well, I guess they achieved that," said David Rosenberg, chief economist and strategist at Gluskin Sheff, which manages USD 6.1 billion.

But the Fed`s actions "weakened the dollar and sparked a boom in commodity prices, which people need to live, to drive their cars and feed their kids," he said. "The report card is very uneven."

A necessary insurance policy

Many investors defended QE2 saying the Fed had to prop up an economy barely removed from the worst recession since World War II and on the verge of a dreaded double-dip recession.

Even with interest rates at zero, recovery had ground to a halt by mid-2010, the jobless rate was rising, and the S&P 500 had shed 250 points in three months, stalling a year-long rally.

A "sustained period of falling prices would have been very damaging for debt, corporate earnings and policy," said Andrew Milligan, head of global strategy at Standard Life Investments, with USD 285 billion under management.

Fed action, he said, largely neutralised that risk.

David Joy, who helps oversee USD 350 billion at Columbia Management, said the Fed action amounted to "taking out an insurance policy so that the recovery could continue."

When it comes to boosting asset prices, that policy has been an unqualified success. But it`s done less to stoke economic growth or raise incomes on Main Street. Average US hourly earnings, when adjusted for inflation, have dropped 1.2 percent in the last 12 months through April. And holding down interest rates hurts those on fixed incomes.

The Fed has cited stock market gains as proof of QE2`s success, but some fear these risks turning the central bank into chief market cheerleader. They also worry that it prolongs a run of credit-driven boom-bust cycles that reward reckless behaviour and punish responsible behaviour -- the sort that in 2008 unleashed the world`s worst financial crisis since the Great Depression.

With QE2 set to end next month, it raises the question: Will the Fed be forced to launch QE3 if the economy worsens, or alternatively, markets fall sharply again?

"Investors and market observers are divided over whether it is a big deal or not," Credit Suisse equity strategist Doug Cliggott wrote in a May 11 note to clients on the approaching end of QE2. "We are in the `it`s a big deal` camp."

Chief cheerleader

Over time, Federal Reserve Chairman Ben Bernanke has become more willing to do what his predecessor never did -- point explicitly to stocks as a sign the Fed is succeeding.

"Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending," he wrote in The Washington Post last November. "Increased spending will lead to higher income and profits that, in a virtuous circle, will further support economic expansion."

In January, Bernanke noted gains in the Russell 2000 index of small-cap stocks as a sign the Fed`s efforts were working. A broader measure, the Wilshire 5000, is up 28 percent, while the MSCI Emerging Markets Index has gained 19 percent.

But equity prices are by nature transitory. Some worry Bernanke`s policies constitute a form of moral hazard that will compel more Fed intervention if stocks fall. It echoes the criticism of those who derided Bernanke as "Helicopter Ben," recalling a 2002 speech -- when he was only a Fed governor -- in which he used the phrase "helicopter drop" to refer to the government`s ability to print money.

"Just imagine what could happen -- every time the stock market declines, people in New York would start making noise and saying `you have to bail us out,`" said Allan Meltzer, a Fed historian and professor at Carnegie Mellon University.

The Fed, Meltzer said, has in recent history been "too concerned about the very near term and too responsive to the cacophony from day traders on Wall Street."

Bernanke`s predecessor, Alan Greenspan, was also criticized for not restraining a spectacular stock market boom that later busted, but he did not single out equity prices as a metric for the efficacy of Fed action.

In fact, Greenspan warned of overemphasizing asset prices in 2005. In a speech in Jackson Hole, Wyoming, he said: "Such an increase in market value is too often viewed by (investors) as structural and permanent."

Higher asset values can have a distorted effect on the economy, as seen through the commodity-price surge. Bernanke has attributed the price surge to supply-and-demand issues, and analysts agree that China`s rapid growth and unrest in the Middle East account for part of it.

But as the Bank of Japan put it in March, "It is safe to say that globally accommodative monetary conditions are a key driver of the rise in commodity prices by stimulating both physical demand and investment flows into commodity markets."

The impact of the commodity surge, says Howard Simons, a strategist at Bianco Research in Chicago, is two-fold: it hurts households by restraining growth and risks inflating asset bubbles that can do immense damage when they burst.

"The problem is people are now trained to believe the Fed stands behind financial markets," Simons said. "But being chief cheerleader is not the role of the central bank."

Markets have become used to something nearing that, judging by the use of the phrase "Greenspan put," and later, "Bernanke put" -- references to the put options used by investors to provide downside protection. The phrase implies the Fed will protect investors from big losses.

Since the commodities rout, more people think the stock market could be in for a reality check, too. Crude oil, which had been closing in on a three-year high near USD 115 a barrel, recently plunged some 10 percent in a day, among its biggest slides in history. A day earlier, silver, which had hit a record, shed 20 percent, its biggest decline since 1980.

Between the March 2010 end of QE1 -- the Fed`s first USD 1.7 trillion asset purchase programme -- and the start of QE2, the S&P fell some 10 percent, and Credit Suisse`s Cliggott says a similar plunge may be in the cards this summer.

That could oblige the Fed to ride to the rescue and "try to put a floor under the S&P," Cliggott wrote. "We don`t know what the `strike` of that put is. Last summer, it was the 1,000 level on the S&P. It may be higher now, it may not be."

Virtuous circles

In addition to boosting stocks, metals, oil futures and other lucrative assets, QE2 also weakened the dollar, which makes US exports cheaper, theoretically helping growth.

Lost in the shuffle, though, are the ordinary savers and consumers who may be facing higher inflation down the road.

Those with savings accounts rather than stock portfolios have been battered by low interest rates.

The jobless rate still stands at 9 percent, and about one in seven Americans receives federal food assistance, according to the US Department of Agriculture.

Housing, where Americans store most of their wealth, is in a deep slump.

Some economists say high energy prices have already started to short-circuit growth. After expanding at a 3.1 percent rate in the fourth quarter, the US economy slowed sharply in the first three months of 2011, growing at a 1.8 percent pace.

Overseas investors and foreign officials also say the Fed`s easy money policy causes inflation. Rising food prices have added to unrest in the developing world, including the Middle East.

Last year, Germany`s finance minister suggested QE2 was designed to depreciate the dollar, which is down about 5 percent this year against a basket of major currencies.

Should a third round be necessary, a more severe devaluation of the dollar could occur.

`Policymaker of last resort`

Barry Eichengreen, professor at the University of California, Berkeley, said laying all these problems at the Fed`s door and expecting it to solve them is misguided.

"The Fed gets pushed into the position of policy maker of last resort," he said. "You would like to see other things done to support the recovery...but you get gridlock on Capitol Hill.

But when the economy weakens, someone has to do something."

Eichengreen said the Fed is sensitive to the notion of a "Bernanke put" and will "try as hard is it can to normalize rates, assuming the economy gains speed."

Rosenberg, though, said the road back to sustainable growth will be a bumpy one, replete with dead ends and detours.

Political opposition to more easing may keep the central bank on the sidelines until 2012, he said. But if things don`t improve, the Fed may have to start QE3, possibly by targeting 10-year yields at a rate low enough to boost home-buying.

"We`re looking at a multi-year transition to the next sustainable economic expansion, and we`re not even close yet," Rosenberg said. "So I think we`ll see QE3 down the road, and by then, people will be begging for it."

Bureau Report