You break it, you own it

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Having identified the success of QE2 with the equity wealth effect, Bernanke has linked US monetary policy with the health of equity markets. Being a bond guy, I always thought this was foolish – but then, as the Bond market front-ran the life out of the Fed, to the extent that yields went up when the Fed started buying, I suppose Bernanke had little choice but to point to equities and break-evens if he wanted to tell a post hoc story.

For what it is worth, I think QE2 was too small to have a meaningful impact on the economy (it was equivalent to around a 50bps reduction of the Fed funds rate). So why do it? The Fed needed to show that they would not accept deflation. In this sense it was a successful strategy. But they also wanted something to take credit for, and the equity bounce is what they chose (channeling Tobin, no doubt).

Compounding their problems, the Fed didn’t explain well what they were doing, and that it is the size of their balance sheet that is the thing and not the flow of their buying. Consequently, just as their balance sheet reached maximum size, and hence policy reached the full planned degree of easiness, the market was flooded with talk of Fed tightening, due ‘the end of QE2’ – as though the Fed planned to sell assets.

To be clear, they have not and do not. They are reinvesting all their redemptions, and as such keeping policy easier than it had been at any time up to June 2011.

After last night’s ~5% plunge in equities, coming after a horror few weeks, which the market has linked to the end of QE2, I think the Fed is going to have to do QE3. Just to stabilize confidence.

They took ownership of the equity market as a foolish PR exercise last year, and then broke confidence with a poor communications strategy. Having broken it, they own it.


  1. QE3 is a dead cert now, but are you game enough to buy in? And if so, when? Its falling knives territory at the moment.

  2. Yes. This is what i was thinking the other day. The reason why Japanese qe didn’t work was because everyone knows the jcb reverses monetary stimulus (i.e. the stimulus was temporary). if the market is expecting the fed’s policy to be temporary, then it wouldn’t work because it isn’t anchoring nominal expectations. the fed has given the market fodder for believing that stimulus would unwind with their reverse repo talk. therefore nominal expectations are becoming unanchored. the knives are falling indeed.

    more qe won’t work effectively unless the fed commits to maintaining nominal expectations. mankiw’s suggestion that the fed level target inflation would go a long way [1]. I’d prefer it to target a market estimate of forward ngdp, but that’s a much much bigger change. level targeting of inflation is a good interim step. [2] what we need isn’t more asset buying. what we need is a new central banking paradigm.


      1. pfft, what shape do you think the credit supply curve has?

        you must think it’s super steep around 25bps if you think that’s what’s keeping reserve balances at 1.6tn (they used to be basically zero all the time pre-crash).

        Assuming diminishing returns to reserves balances, i would think that credit is basically unconstrained by reserves, and that demand is the problem.

  3. Also, im no economist, and so will defer to your better judgement re wealth effect. i am also not as close a fed watcher as you, but i must challenge what you say re fed linking qe2 with wealth effect via equity markets. i think they used the equity market response as evidence that the market thought that it would put the economy on a better trajectory, than otherwise would have been the case. you point to qe effect of 50bps (Hamilton?). thats prob true. imagine the macroeconomic value of having a monetary regime in place that anchors nominal expectations and monetary easing. seeing as i need a coffee, it would be like having a double shot ristretto nicely cut and made vs having a watered down nescafe blend 43.

  4. Oil is finally crashing down and so are other commodities and this will push the world economy (China + USA) a lot more than any bloody QE3, of any amount!
    Hasn’t Ben understood yet that a STRONG dollar (the world reserve currency by the way) is REALLY in the interest of the world economy? I really hope they do not panic in the same way as the markets are, and hold off any intervention. Now that oil is down, and all commodities will follow the economy can restart by itself. With QE3, oil will be back at $100 and the US economy will go nowhere, like in H1 2011, when the stupid QE2 was happening!

  5. I think what the Australian economy needs now is three rate hikes by Christmas to control inflation (No really, Chris Joye actually said that last week).

    Bill. Evans. Was. Right.

    When do you guys admit that you were hopelessly wrong and utterly clueless?

    1. Oh, the obvious retort hasn’t been made yet. Bill. Evans. Hasn’t. Been. Proved. Right. Yet. That’s going to take another 12 months to ascertain.

    2. You diminish your arguments with your tone.

      I don’t think Bill was forecasting a 10% drop in equities over the last few days. If i had that forecast, as well as the extra knowledge about CPI I have learnt since, I would have voted to sit at 4.75%

      I didn’t know these things last week.

      Sent from my iPad

      1. It’s eerily similar to the 2008 crash…. I am not saying it will develop in the same way from here, in the next few weeks… but also in 2008 inflation was running high too, oil was > $100, the AUD was at new highs, and the RBA was tightening because of the commodity boom!
        There is something I really do not understand: when a currency goes down to US$ 0.60 then up to $1.10 in 2 (!) years, with similar gains vs. most other currencies, and the long term average is about $0.80, how can that be not destabilizing for a small economy like ours?

      2. You diminish your arguments with your tone.

        Perhaps, but in my defence there has been staggering lack of sympathy from your side for the plight of the non-mining economy, and most particularly, the non-mining trade exposed sectors. We have been screaming from the rooftops for months about how grim things are, but have been lectured that we need to “free up” our labour to “make room” for the mining boom.

        Policymakers have become completely obsessed with the China growth story and the mining investment boom in recent months and have ignored the rapidly deteriorating domestic economy, where most Australians live and work. Its got to the point where the RBA board has been accused of being dysfunctional because it includes members from the domestic business community. All I can say, is thank Christ Corbett, Akehurst and Kraehe pushed back against the funster and “boom boom” Battellino. If they’d started hiking earlier this year (as the bullhawks demanded) there is little doubt non-,mining Australia would be recession now. It may be in recession anyway.

        I see the ANZ is now tipping rate cuts. What pathetic weather vanes. Was it less than a week ago they were pushing for a hike in August.

  6. @ Lorax — yes i have little sympathy for the dutchies, but it’s not because i’m heartless, it’s because there are no welfare increasing solutions to the problem of a terms of trade boom. The price signal is too big to resist anyway. Well, that is, absent a mining tax …

    We should have a 70% MRRT, like Norway. Nothing the ALP can ever do will make up for messing that policy up so badly.

    1. Agreed 100% on the MRRT, but it doesn’t help when you have an opportunist like Abbott screaming “Great Big New Tax” everytime government proposes any kind of tax reform. Besides, we’ve allowed the miners to become too powerful politically anyway. Gina and Twiggy have very deep pockets, and will spend whatever is necessary to sway public opinion, and therefore policy.

      As for there being “no welfare increasing solutions to the problem” perhaps that is true in aggregate, but when the majority of Australian households are experiencing recessionary conditions, one wonders WTF is the point of this “boom”? Seeing mining magnates get fabulously wealthy and spending up big on football teams and Ferraris is little comfort for the average suburban Aussie struggling with their mortgage repayments. If some more of mining bonanza was being collected by government and saved for a rainy day, or invested for a post-mining boom future, perhaps we’d all feel better about the boom. But its not.

    2. Bill Evans points out the bleeding obvious today….

      We are particularly surprised by the growth outlook over the course of 2011. With the consumer cautious; house building outlook flat; and (non mining) business investment soft we cannot see how the rebuilding program and the export recovery can possibly generate growth at a 6 per cent annualised pace for three consecutive quarters.

      1. No one is any good at forecasting, and these listy forecasts are just for media. Top down VARs out perform almost all the time.

        Sent from my iPad

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