QE2 Saved the Economy -- and May Tank It Again, Too
Remember deflation? Prices appeared to be circling the drain last summer, raising fears of a Japanese-style "lost decade" of spiraling personal debt, falling wages and economic stagnation. Well, you can stop worrying -- at least about that particular malaise.
Quantitative easing, the Federal Reserve's much-maligned policy of buying long-term Treasury bonds as a way to pour money into the U.S. economy, is working. Since Fed chairman Ben Bernanke announced a second dose of this medicine in August, prices have reinflated, the stock market has risen and the dollar declined, which boosts exports.
Most important, consumer spending is growing faster than it has since 2007, propelled by rising confidence and the bullish market. That has helped lift GDP growth from 2.6 percent through most of 2010 to 3.2 percent in the fourth quarter (UPDATE: Since this post was published fourth-quarter growth has been revised downward to 2.8 percent.) Even QE2 skeptics such as Dallas Federal Reserve Bank head Richard Fisher concede that the policy has kept the economy from tipping back into recession. As he recently told the WaPo:
Whether you think we have done too much or the right amount, I think it's hard to dispute the fact that the Fed has reliquified the economy. I don't think you can criticize the Fed for not having done their job.Inflation worries return
Is QE2 responsible for putting the economy on the right track? Probably, says Harvard economist Martin Feldstein:
To be sure, there is no proof that QE2 led to the stock-market rise, or that the stock-market rise caused the increase in consumer spending. But the timing of the stock-market rise, and the lack of any other reason for a sharp rise in consumer spending, makes that chain of events look very plausible.The policy has worked well enough that Federal Reserve Bank of St. Louis chief James Bullard suggested in a presentation this week that it's time to consider tapering back on bond purchases or even ending the program months before its planned June completion date.
And perhaps for good reason. Because for U.S. consumers, the major risk is no longer deflation, but rather good old-fashioned inflation driven by the Fed monetizing government debt. Although prices as a whole are flat, energy and food costs are rising. The U.S. Agriculture Department projects that food prices will increase 3-4 percent this year. Meanwhile, turmoil in the Middle East is already causing gas prices around the nation to spike. Such increases hurt all the more given that household income has steadily declined in recent years, while another source of wealth -- home equity -- continues to fall.
How QE2 fuels bubbles
Whatever good the Fed's purchase of $600 billion in U.S. Treasurys is doing here at home, it may be causing damage abroad. One result of QE2 is that bondholders move their money into equities and other assets. That has been good for U.S. stock prices, but it also appears to be funneling money into commodities such as wheat and precious metals. Among other effects, that is pushing up food prices, especially in poorer parts of the world. TheAtlantic.com's Derek Thompson has an excellent explanation of how this works:
To understand why QE2 could drive up food prices, imagine that you are a banker who has sold some sticky assets to the Fed for fresh cash. Where do you put this money to get the highest return? You can invest in low-risk U.S. companies, but they're also low-reward. You could invest in high-reward emerging markets, but they're also high risk. Or, you can make a bet on commodities like metals and food where demand from emerging economies seems limitless.The danger of asset bubbles, unintended or not, highlights another critique of QE2 -- that it doesn't channel money into productive parts of the economy. Boosting the stock market temporarily boosts paper wealth, but such gains may be fleeting. And all that easy money courtesy of the Fed chiefly benefits investors at liberty to scour global markets in search of the highest returns. Why? Because while the Fed can print money, it can't control where it goes.
And when the music stops playing?
That relates to a broader concern about QE2 -- whether its positive effects for the U.S. economy are sustainable. The Fed isn't expected to re-up for another round of bond purchases after the current program ends this summer. As Feldstein asks, what happens to the stock market then? If it falters, perhaps amid renewed fears about Greece defaulting on its debt or oil prices shooting through the roof, consumers and business might stop spending and investing. And if inflation continues to rise, then the Fed will eventually be forced to raise interest rates, further undercutting the recovery by hurting demand for loans.
Those twin pressures -- to buoy the U.S. economy without harming our global trading partners -- put the Fed in a bind. Withdraw QE2 too soon and risk slipping back into recession; withdraw it too late and risk aggravating global inflation, which is likely to land right back in our laps. We can ship rising prices overseas for a while, but not forever.
Of course, it's worth remembering why the Fed had to apply the lash in the first place -- politicians refused. The economy really was sliding backwards when Bernanke floated the idea of QE2, and not as a result of the federal deficit that Congress and the White House are so obsessed with. What the government really needs to do is spend. Monetary policy can keep the country on the road to recovery, but it can't bring us home.
Thumbnail from Wikimedia Commons, CC 3.0
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