The Federal Reserve continues to cling to a destabilising and ineffective strategy. By maintaining its policy of quantitative easing (QE)—which entails monthly purchases of long-term assets worth $85 billion—the Fed is courting an increasingly treacherous endgame at home and abroad.
By now, the global repercussions are clear, falling most acutely on developing economies with large current-account deficits—namely, India, Indonesia, Brazil, Turkey, and South Africa. These countries benefited the most from QE-induced capital inflows, and they were the first to come under pressure when it looked like the spigot was about to be turned off. When the Fed flinched at its mid-September policy meeting, they enjoyed a sigh-of-relief rally in their currencies and equity markets.
But there is an even more insidious problem brewing on the home front. With its benchmark lending rate at the zero-bound, the Fed has embraced a fundamentally different approach in attempting to guide the US economy. It has shifted its focus from the price of credit to influencing the credit cycle’s quantity dimension through the liquidity injections that quantitative easing requires. In doing so, the Fed is relying on the “wealth effect”—brought about largely by increasing equity and home prices—as its principal transmission mechanism for stabilisation policy.
There are serious problems with this approach. First, wealth effects are statistically small; most studies show that only about 3-5 cents of every dollar of asset appreciation eventually feeds through to higher personal consumption. As a result, outsize gains in asset markets—and the related risks of new bubbles—are needed to make a meaningful difference for the real economy.
Second, wealth effects are maximised when debt service is minimised—that is, when interest expenses do not swallow the capital gains of asset appreciation. That provides the rationale for the Fed’s zero-interest-rate policy—but at the obvious cost of discriminating against savers, who lose any semblance of interest income.
Third, and most important, wealth effects are for the wealthy. The Fed should know that better than anyone. After all, it conducts a comprehensive triennial Survey of Consumer Finances (SCF), which provides a detailed assessment of the role that wealth and balance sheets play in shaping the behavior of a broad cross-section of American consumers.
In 2010, the last year for which SCF data are available, the top 10% of the US income distribution had median holdings of some $267,500 in their equity portfolios, nearly 16 times the median holdings of $17,000 for the other 90%. Fully 90.6% of US