Macro Focus: To QE or not to QE, That is the Question.

Tues, JUN 26th, 2012

Whether ’tis Nobler in the mind to suffer, The Slings and Arrows of outrageous Fortune, Or to take Arms against a Sea of troubles …” Bill Shakespeare once opined.

Often discussed, debated, and over-analyzed is what arguably is the quintessential and most pressing economic question relevant today: Is QE [quantitative easing] working to assuage our Sea of economic troubles?

To some extent.

Unmistakably, these monetary programs had more punch to both stocks and the real economy in the first two iterations. It certainly seems that the more numbers you add to QE the less thrust it has. Many ask if Fed intervention is the right step. Regardless of whether it’s right or wrong, it’s necessary medicine. To be sure, you cannot cure a debt crisis with more debt, but you can buy time [cliche alert: kicking that can down the road] while policymakers [hopefully] implement pro-growth structural reforms. To wit, the only way to cure a debt crisis is with economic growth. Fed policy makers are doing the best they can given a bad situation.

The real problem is the transmission mechanism. The Fed is pushing against a string here. U.S. banks have tons of liquidity, it’s the transfer of that cash into the real economy via lending [credit creation] that is the problem. Banks aren’t eager to lend, and to be completely frank there isn’t much new loan demand for revolving lines anyway — the kind of credit that provides a boost to continuous purchasing power. We are in the throes of a deleveraging cycle and you cannot force more food down the throat of the stuffed buffet patron. They have to want it.

So we’re left to wonder: What’s the Fed’s strategy here? It’s not a pleasant answer, but it’s all they’ve got — the wealth effect. Bernanke believes that as more money is pumped into the system [even with a broken transmission] market participants must follow suit and sell safe havens to buy stocks [old Wall Street adage: You can’t fight the Fed]. This nudging of investors along the risk curve causes stock prices to rise and thus households “feel” more wealthy. This feeling, the thinking goes, results in increasing consumption patterns [demand], which helps keep the economy humming. Many do not believe this wealth effect actually happens. I, too, am skeptical based on the premise that most economic studies — including our own research — demonstrate that people make the bulk of their purchasing decisions on their “permanent” income streams [e.g. salaries and wages] not on transitory fluctuations [like stock prices]. Rising stock prices do very little to change the underlying stream of cash flows.

So what’s the point?

While I believe the wealth effect offers very little long-run benefit, it does seem to ever-so-slightly alter consumption over the short-run. Studies have consistently shown that a 1% rise in stock values can add an ephemeral 0.04% to GDP growth. I argue, however, that this is not because people actually feel wealthier, but rather it’s because so many use the stock market as a quick gauge of the overall health of the economy. Consumers don’t spend money on a good or service because the value of their 401k is up. But, if the market is rising the conclusion drawn is that the economy must be doing OK and this psychological reprieve can influence small short-run decisions. Therefore, while the bulk of purchases are tied to salaries and wages, there can be a marginal effect to goosing stock prices. Therein lies the benefit for QE. But how given this anemic and short-run response?


The long-run is but a string of short-runs and broad stock market reaction to the last three Fed programs resulted in bold run-ups [mean increase of 47%]. Undeniably, QE1 offered an outsized portion of this. When stripping out QE1 the resulting mean is still a spirited 30% [median, 33%]. Under the assumption that the relationship has held-up post-2008, nearly 1.2% of additional GDP growth was forged with each program. The Fed likely believes [or clearly hopes] this correlation remains given its current approach to policy. Under the assumption that another QE program bestows upon stocks the unbroken trend of positive but diminishing returns, say something like 15-20%, this could theoretically produce 0.6-0.8% of GDP bump. While it isn’t much, it’s something. It’s not contraction. It’s not complete loss of economic momentum. It’s not falling sentiment. It’s not deflation.

These alternative outcomes would likely be the result if they simply did nothing [as many advocate]. But, they won’t. They cannot sit on their hands while their dual-mandate of price stability and employment implodes. They can print, and without imminent fear of run-away inflation due to above-trend resource slack in the economy — especially in labor, but also in fixed-asset utilization rates. This notion has been validated by a nearly $2T [yes, trillion!] expansion in the Fed’s balance sheet since 2008 yet inflation has persisted, for the most part, under the 2% target set by the Fed. Until this resource slack tightens the Fed has bullets and they will fire them as they see fit.

The Fed surely cannot leave our economic fate with Congress in hopes of a fiscal solution. That’s about as reliable as allowing kids to grade their own homework. Nope. What Bernanke & Co. must do is something, and this infinite-QE something is the strategy they choose to target given the available resources.

How long must we ride this wave?

Could be many years, but nobody really knows for sure. To paraphrase Bill Gross: We are in quicksand and the Fed is on dry land extending a hand. This is a long workout and high economic growth [>4% real GDP growth] and dependable double-digit stock returns are likely a thing of the past. At least for the foreseeable future, anyway.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200

About Albion Financial

Established in 1982, Albion Financial Group is an independent, fee-only financial planner and investment manager located in Salt Lake City, Utah.