Something About Quantitative Easing !!!

The impact of Quantitative Easing operations undertaken by Central Banks in the developed world is an intensely debated topic and has sharply polarised opinions across academia, financial markets and the popular media. However, as with the debate on austerity versus spending, the  discussion tends to get clouded by firmly held ideological biases rather than focusing on empirical based arguments. With that aim in mind, I summarise below a recent note by Roger Farmer, head of the economics department at UCLA, which argues why central banks should do a lot more to reduce unemployment and boost economic growth.

In a series of recent academic work , Professor Farmer has argued that there is a stable, and causal, relationship between the stock market and the unemployment rate.  And that the stock market crash of 2008, triggered by a collapse in housing prices, caused the Great Recession, and therefore the Fed can do a lot more to lower the unemployment rate by impacting the stock market..

-The chart below illustrates that in normal times the Fed’s balance sheet consists mainly of treasury securities, and that after the Lehman shock of 2008 and the ensuing freefall of the stock market, its balance sheet went from $800BN to over $2 trillion in the space of a month, as it engaged in a variety of lending programmes.

-As the chart also clearly shows, the stock market rally began in  March 2009 when the Fed began purchasing mortgage securities, and began to fall once the QE1 programme ended a year later. The market then began its ascent In  August 2010 when the Fed announced QE2 at its annual Jackson Hole conference.

-Fed policy not only influences markets, it has a big impact on the average citizen as all forms of wealth tend to move up and down together. A person’s wealth is tied-up in his future earnings,  and when the stock  market plummets the prospects of the average worker decline as well. His research has shown that when the stock market rises, unemployment falls and when the stock market crashes a recession ensues.

-Suppose an economist working in the 1970s was trying to predict the unemployment rate three months forward by looking just at the average unemployment rate and the real value of the stock market in the previous two quarters,  his predictions would have been very accurate in that era as well as the more recent era.

Market are moved by sentiment, but these movements have a big impact on our lives through the job market  - as plunges in  financial wealth can lead to devastating  job losses.  The Fed can do a lot more.

An interesting  empirical argument which  illustrates  that central bank actions to expand balance sheets  can positively impact the  stock market as well as the real economy. While an environment of deleveraging and zero short-term interest rates can limit the full impact of monetary policy, it is all the more necessary to take aggressive monetary action, particularly given that governments across the developed world are constrained by their  inability to do more on the fiscal front. Aggressive balance sheet expansion lowers  the real interest rate (by increasing inflationary expectations) which is a powerful tool to boost aggregate demand and increase investment spending.  It is therefore inevitable that the Fed and the ECB will have to do a lot more to buoy the stock markets and the economy, as the process of deleveraging and fiscal constraint continues.