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The United States Federal Reserve’s decision to undertake a third round ofquantitative easing, or QE3, has raised three important questions. Will QE3 jump-start America’s anemic economic growth?Will it lead to a persistent increase in risky assets, especially in US andother global equity markets? Finally, will its effects on GDP growth and equitymarkets be similar or different?
Many now argue that QE3’seffect on risky assets should be as powerful, if not more so, than that of QE1,QE2, and “Operation Twist,” the Fed’s earlier bond-purchase program. After all,while the previous rounds of US monetary easing have been associated with apersistent increase in equity prices, the size and duration of QE3 are moresubstantial. But, despite the Fed’s impressive commitment to aggressivemonetary easing, its effects on the real economy and on US equities could wellbe smaller and more fleeting than those of previous QE rounds.
Consider, first, that the previous QE rounds came at times of much lowerequity valuations and earnings. In March 2009, the S&P 500 index was downto 660, earnings per share (EPS) of US companies and banks had sunk to afinancial-crisis low, and price/earnings ratios were in the single digits.Today, the S&P 500 is more than 100% higher (hovering near 1,430), theaverage EPS is close to $100, and P/E ratios are above 14.
Even during QE2, in the summer of 2010, the S&P 500, P/E ratios, andEPS were much lower than they are today. If, as is likely, economic growth inthe US remains anemic in spite of QE3, top-line revenues and bottom-lineearnings will turn south, with negativeeffects on equity valuations.
Moreover, fiscal support is absent thistime: QE1 and QE2 helped to prevent a deeper recession and avoid a double dip,respectively, because each was associated with a significant fiscal stimulus.In contrast, QE3 will be associated with a fiscal contraction, possibly even alarge fiscal cliff.
Even if the USavoids the full fiscal cliff of 4.5% of GDP that is looming at the end of theyear, it is highly likely that a fiscal dragamounting to 1.5% of GDP will hit the economy in 2013. With the US economycurrently growing at a 1.6% annual rate, a fiscal drag of even 1% impliesnear-stagnation in 2013, though a modest recovery in housing and manufacturing,together with QE3, should keep US growth at about its current level in 2013.
But there is no broader reboundunderway. In both 2010 and 2011, leading economic indicators showed that thefirst-half slowdown had bottomed out, andthat growth was already accelerating before the announcement of monetaryeasing. Thus, QE nudged along an economythat was already recovering, which prolongedasset reflation.
By contrast, the latest data suggest that the US economy is performing assluggishly now as it was in the first half of the year. Indeed, if anything,weakness in the USlabor market, low capital expenditures, and slow income growth have contradicted signals in the early summer thatthird-quarter growth might be more robust.
Meanwhile, the main transmissionchannels of monetary stimulus to the real economy – the bond, credit, currency, and stock markets – remain weak, if notbroken. Indeed, the bond-market channel is unlikely to boost growth. Long-termgovernment bond yields are already very low, and a further reduction will notsignificantly change private agents’ borrowing costs.
The credit channel also is not working properly, as banks have hoarded most of the extra liquidity from QE,creating excess reserves rather thanincreasing lending. Those who can borrow have ample cash and are cautious aboutspending, while those who want to borrow – highly indebted households and firms(especially small and medium-size enterprises) – face a credit crunch.
The currency channel is similarly impaired. With global growth weakening,net exports are unlikely to improve robustly, even with a weaker dollar.Moreover, many major central banks are implementing variantsof QE alongside the Fed, dampening theeffect of the Fed’s actions on the dollar’s value.
Perhaps most important, a weaker dollar’s effect on the trade balance, andthus on growth, is limited by two factors. First, a weaker dollar is associatedwith a higher dollar price for commodities, which implies a drag on the tradebalance, because the USis a net commodity-importing country. Second, any improvement in GDP derivedfrom stronger exports leads to an increase in imports. Empirical studiesestimate that the overall impact of a weaker US dollar on the trade balance isclose to zero.
The only other significant channel to transmit QE to the real economy isthe wealth effect of an equity-market increase,but there is some circularity in theargument that QE3 will lead to a persistent rise in equity prices. Ifpersistent asset reflation requires asignificant GDP growth recovery, it is tautologicalto say that if equity prices rise enough following QE, the resulting increasein GDP from a wealth effect justifies the rise in asset prices. If monetarypolicy’s transmission channels to the real economy are broken, one cannotassume that QE will have a significant effect on economic growth.
Fed Chairman Ben Bernanke has recently emphasized the importance of anadditional channel: the confidence channel,through which the Fed’s commitment to maintaining generous monetary conditionsfor longer could improve private spending. The issue is how substantial anddurable such effects will be. Confidence is fragilein an environment characterized by ongoing deleveraging,macro uncertainties, weak labor-market growth, and a fiscal drag.
In short, QE3 reduces the tail risk ofan outright economic contraction, but isunlikely to lead to a sustained recovery in an economy that is still enduring apainful deleveraging process. In the short run, QE3 will lead investors to takeon risk, and will stimulate modest asset reflation. But the equity-price riseis likely to fizzle out over time ifeconomic growth disappoints, as is likely, and drags down expectations aboutcorporate revenues and profitability.
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