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.