The Three Costs of QE3

There are three major costs of the Fed’s just announced QE 3 that we should probably start talking about now that the initial magic has worn off in the equity markets.  So let’s all towel off and focus.

I’ve heard these items discussed elsewhere but in much different terms – either for the purpose of conveying anger about fiat money or in a pedantic manner so as to impress the novice reader.

But the good professor Aswath Damodaran (Professor of Finance, Stern School of Business at NYU) has a really simple explainer up at his blog Musings on Markets.  He is skeptical of the stock market rally that followed Bernanke’s new program details because a) we’ve tried it already and b) it has costs attached to it that many equity investors may be overlooking…

1. The inflation factor: The biggest cost of an expansionary monetary policy is the potential for inflation that comes with it. I know that the low inflation over the last few years has led some analysts to conclude that the inflation dragon has been slain forever.  However, history tells us that inflation is like a deadly virus, harmless as long as we can keep it trapped, but hard to control, once it escapes. Put differently, if the Fed has miscalculated and high inflation does return, the cure will be both long drawn out and extremely painful.

2. Artificially “low” interest rates create winners and losers: If the Fed’s bond buying is keeping interest rates at “artificially” low levels, not everyone wins. Among individuals, spenders are rewarded and savers are punished, a perverse consequence in a nation that already saves too little for the future. Among businesses, you reward those businesses that have to raise fresh capital, and especially those who are more dependent upon debt, and punish more mature and/or equity-focused businesses. Among sectors, you help out those that are more dependent upon debt-funded consumption (housing, durable goods) and do less for service businesses. Thus, keeping interest rates “abnormally” low may create bubbles in some sectors and encourage people to act in ways that are not good for the economy’s long term health.

3. Credibility effect: The powers of a central bank stem less from its capacity to print money (any central bank can do that) and more from its perceived independence and credibility, and I think the Fed has hurt itself on both counts. While I am willing to believe that the Fed acted without political considerations, any major action two months ahead of a presidential election will viewed through political lens, and it is natural for people to be suspicious. In addition, each time the Fed takes a shot at the “real growth” pinata and nothing happens, it damages it’s credibility. Much as the market (and some economists) may welcome and justify QE3, but the ultimate test is in whether it will give a boost to real economic growth and if that does not occur, what’s next?

Very well put. The contra argument is that these costs/risks are preferable to the alternative – the Fed does nothing, the economy rolls into a new recession and the cyclically unemployed become structurally unemployed, further disconnected from the labor market with skillsets growing more obsolete each week.

The problem with taking the other side is that now that Bernanke did hit the panic switch, yes stocks rally for a few weeks but do we actually get jobs growth? Not so sure, are you?

Source:

Inspiration or Insanity? Fed action and Market Reaction (Musings On Markets)