Over the past several weeks, financial markets have been extremely volatile. The yield on the 10 year U.S. Treasury increased by about 50 basis points (29%) to 2.15%, and the S&P 500 has swung up and down by 80 points (about 5%). The proximate cause of the increase in volatility was Fed Chairman Bernanke's May 22 Congressional testimony, where he suggested that the Fed could slow its purchases of assets from the current $85 billion monthly pace. By reducing longer term interest rates, Fed asset purchases suppress the discount rates applied to all future cash flows, which boosts stock and real estate prices. The recent volatility is a reminder of the extent to which asset prices have become dependent on Fed policy and the huge risks created by the Fed's ongoing intervention.
The case for quantitative easing is straightforward. The Fed has a "dual mandate" to achieve both price stability and full employment. With inflation low, unemployment elevated, and the employment-to-population ratio near its all-time low, the Fed would normally reduce interest rates. But since the Fed's main policy rate – the overnight federal funds rate – is already at zero, any additional loosening of monetary policy has to occur through "nonstandard" policies. These have generally taken the form of "quantitative easing", whereby the Fed purchases Treasury bonds and mortgage-backed securities (MBS) from banks with newly created reserves (i.e. "printing money.") By removing Treasury bonds and MBS from the market, the Fed makes them more scarce, which drives up their price and reduces their yield.
The direct impact of reductions in Treasury and MBS yields is to lower the effective borrowing costs of the Federal government and mortgage borrowers. This allows the Treasury to run larger deficits at a lower cost than would otherwise be the case. Lower borrowing costs spurs mortgage refinancing and new mortgage purchases, which increase household cash flow an! d increase house prices. Recent data suggest that house prices have increased by about 10% nationally since the beginning of 2012. Lower Treasury rates also lead to lower borrowing costs for nonfinancial businesses. By swapping out interest-bearing assets for bank reserves that pay just 0.25%, Fed policy also reduces the foreign exchange value of the dollar by reducing the aggregate interest payments in dollar money markets.
Finally, by reducing discount rates and increasing asset prices, Fed policy should also increase spending of households and businesses through "wealth effects". As households feel wealthier, they are willing to spend a greater portion of current income. Similarly, business investment is generally tied to the net worth of the business, so as stock prices increase, a business is naturally inclined to invest so as to capitalize on the higher multiple the market assigns to its assets and income.
While all of this may make a great deal of sense in theory, the problem is that the reduced financing costs and increased wealth have not translated into more spending by businesses and households. The bulk of the business borrowing done over the past four years has gone to refinance existing debt. This has increased business cash flow and cash holdings, but not translated to higher wages, employment or investment. All three remain historically weak. Households with good credit and lower than average loan-to-value ratios have been able to refinance mortgage debt, but tighter credit standards and the large share of mortgages "underwater" has limited the effectiveness of lower interest rates. Although house prices in Las Vegas and Phoenix have increased by about 25% from their lows, they remain about 50% below their 2006 peaks. As a result, homeowners who purchased in 2006 and 2007 still owe more than their house is worth, which prevents refinancing.
Businesses and households have not responded to higher asset prices for two reasons. First, as demonstrated by ! the recen! t volatility following Bernanke's testimony, there is a sense that current asset prices are artificially inflated. Households do not feel wealthier if they think the value of their portfolio is likely to fall as soon as the Fed removes accommodation; businesses are not likely to invest if they worry that a change in Fed policy could cause their stock price to fall suddenly. Second, wealth effects have historically arisen due to expectations of higher expected earnings. If the increase in asset prices are due to lower discount rates being applied to the same expected earnings, there is no increase in wealth because higher returns today are simply offset with lower expected returns in the future. Hence, manipulating stock prices higher is not likely to have the same effect on spending as stock price increases generated by expectations of higher future incomes.
If lower interest rates and higher asset prices do not spur more spending in the real economy, it is reasonable to wonder if quantitative easing is more trouble than it's worth. When longer-term interest rates shoot upwards by one-third and stocks lose 5% of their value when the Fed hints that it may slow asset purchase volumes, it is difficult to conclude that the current policy is generating durable gains in economic activity. The main effect of Fed policy is to generate large but temporary increases in asset prices. This benefits traders and other financial intermediaries whose compensation is tied to current period returns, but actually reduces the confidence of households and business managers when the asset prices increases are later shown to have been artificial as has been the case over the past several weeks.