The Mysterious Case of the Misfiring Monetary Policy

By Karen Shaw Petrou

When former Fed Chairman Bernanke launched a new approach to U.S. monetary policy earlier this year, he prompted many within and outside the U.S. central bank to call for sweeping change that would solve the “mystery” Janet Yellen says bedevils post-crisis monetary-policy transmission.  Just like the blue carbuncle Sherlock Holmes eventually found inside a large goose, central bankers are searching for a new gemstone within reams of data by which to guide increasingly complex policy-transmission channels. 

Simply put, the Fed and most other central bankers now know that they don’t know why – despite trillions on the central-bank balance sheet and real rates often well below the zero lower bound – growth, productivity, inflation, and wages simply aren’t doing what all the long-trusted models say they should.  The blue carbuncle?  It’s that post-crisis monetary policy has reallocated asset valuations, damaging both income and wealth recovery for all but the richest U.S. households.  Any new approach to monetary policy under a new Fed chairman that fails fully to account for economic-inequality effects will be as disappointing as the current Fed approach even as macroeconomic growth stutters, market-stability falters, and political polarization goes farther into the red zone (see a previous blog post for how risky this all will prove). 

Launching his monetary-policy redo, Bernanke stood resolutely by the current Fed’s stout insistence monetary policy doesn’t adversely impact economic equality – far larger forces are at work, say Bernanke, Yellen, and Powell.  A new BIS staff paper – one of the most comprehensive and current of all of the QE-impact research – may lead the Fed to rethink its head-in-the-sand strategy.  It for sure should. 

In perhaps its most important result, this BIS staff paper finds that QE’s peak impact – that is, its impact across the years and all of its trillions – in the U.S. had ten times more effect on stock prices than on maximum output.  Importantly and dramatically, the Fed’s first, desperate, and sudden QE program in 2009 (QE1) had very significant impact on near-term GDP growth.  This is because the market did not expect QE1 and thus behaved largely as the Fed anticipated. 

However, QE’s overall impact fades to favor only the equity markets – not the macroeconomy – as subsequent programs (QE2 and QE3) wended their amply-signaled way through financial markets increasingly inured to large Fed positions and hungry for the yield required to salvage damaged business models.  QE3 remains almost fully in effect as of this writing, with the Fed’s balance sheet standing very close to the $4.5 trillion the central bank amassed in all these QE exercises.  The current portfolio is being finally but very, very gradually phased down, but only to a new total – some say $3 trillion – that would leave the Fed very much at the center of the economic universe.  As a result, QE3’s adverse implications will be a permanent feature of the U.S. financial system.

Perhaps the Fed and other central banks didn’t cause an equity-price bubble that made the richest people in the world $1 trillion richer at a rate four times faster than just the year before.  Maybe, but the correlation shown in this BIS paper and other research between later QE and equity prices is so consistent as to suggest causality even if one doubts this most recent study and many others concluding that the $14.2 trillion on major central-bank’s balance sheets made a bit of a difference.

Further, this new BIS study concludes that, over time, QE’s net impact fades to zero even though higher equity prices remain persistent.  One could of course argue that exogenous factors (e.g., regulatory or tax policy) affect equity prices.  However, while the BIS paper finds a weaker link between QE and equity prices over time, it still concludes that the most significant underlying force behind resilient, higher equity prices is the yield-chasing spawned by both QE and ultra-low interest rates.

In fact, one critical contribution of this new paper is to link QE to ultra-low rates and the impact these have on financial stability and financial intermediation – two phenomena with their own, critical equality impact regardless of what QE might on its own do.  BIS staff repeat long-accepted thinking to point out that ultra-low rates lead to yield chasing evident not only in sharp equity-price increases, but also in skimpy risk premiums across the financial system.  When productive assets key to economic equality such as small-business lending or first-time mortgages have to compete with high-yield credit, they lose.  Financial-asset allocations thus support speculation and share buy-backs, not sustainable growth.

The BIS paper does not address another critical issue:  QE’s impact on safe-asset scarcity and how this limits bank credit capacity and collateral availability.  These QE-caused phenomena of course contribute mightily to procyclicality risk (less politely known as zombie lending) and undermine bank resilience. 

The BIS paper does fret about bank earnings undermined by ultra-low rates.  I would add to this reduced earnings when judged on the return-on-equity basis critical to market capitalization and franchise preservation.  It also notes that all of the factors it studies – QE, stock prices, and ultra-low rates – adversely affect long-term financial security for households not lucky enough to join the mega-billionaires in the equity-market’s shindig.

In short, QE in concert with ultra-low rates that persist well into a post-shock financial market with ample advance signaling in concert with lots of post-crisis rules run counter to the fundamental purpose of all of this financial policy:  GDP growth that lifts employment to restore economic equality in a financial system that mitigates the risk of a great-financial-crisis repeat.  Not only should the Fed take rapid actions to correct its post-crisis mistakes, but it must also be sure it doesn’t repeat them as a new Fed begins to redesign the U.S. system in 2018.