Doubts about the scale and effectiveness of an expected Federal Reserve effort to buoy the economy roiled financial markets Wednesday.
U.S. stock prices sagged in morning trading, as investors weighed news reports that a Fed program of bond purchases, designed to stimulate growth, will be modest in size. Such asset purchases are viewed by economists as one of the few viable tools left in the Fed’s arsenal, since official short-term interest rates are already near zero percent.
Experts on monetary policy, both inside and outside the Fed, are divided over whether this so-called quantitative easing program will work. It’s called “quantitative” because the buying of assets like treasury bonds will expand the size of the Fed’s balance sheet. It’s called “easing” because the plan could push down real long-term interest rates, helping to fuel growth.
The worries are hitting financial markets days ahead of the Fed’s expected approval of this new policy, at a meeting next week.
Some finance experts support the Fed’s effort but worry it will be too small to do much good. Others see quantitative easing as a misguided effort that will probably backfire, igniting inflation while failing to help the U.S. economy.
The criticism is summed up, Halloween-style, in a new report by prominent investment strategist Jeremy Grantham titled “Night of the Living Fed.”
“By increasing inflation fears, this [widely anticipated] easing has sent the dollar down and commodity prices up,” Grantham says in the report, which arrived to clients complete with a creepy mock movie poster at the top. The new easing, combined with other moves by the Fed, makes central bank policy “a large net negative to the production of a healthy, stable economy with strong employment,” he argues.
Although the mainstream view of the Fed is more charitable, economists generally expect the positive impacts from quantitative easing to be limited. And any positives come with risks.
“Quantitative easing isn’t a silver bullet for the fragile U.S. recovery,” Mark Zandi, chief economist of Moody’s Analytics, writes in a recent analysis. But, he contends, “the benefits significantly trump the costs.”
Economists at the investment firm Goldman Sachs said Friday that they expect the Fed will initially move to buy about $500 billion in assets over the course of six months. On Wednesday, a story in The Wall Street Journal sounded a similar note.
How much impact could quantitative easing have on the economy? William Dudley, president of the Federal Reserve Bank of New York, recently cited one estimate: Purchases of $500 billion in bonds, he said, “would provide about as much stimulus as a reduction in the [short-term interest] rate of between half a point and three-quarters of a point.”
The asset purchases might affect the economy through several channels, economists say.
Lower long-term interest rates (in real or inflation-adjusted terms) could spur borrowing and allow borrowers to have more free cash for other purposes after covering their costs of credit. The Fed program could boost stock prices by making investors more confident about an economic recovery. That, in turn, could lift businesses’ spirits and reduce their cost of raising capital in the stock market. And a lower dollar, against other currencies, should help US exports be more competitive in world markets.
But the idea comes with huge question marks. For one thing, the Fed could have hard time developing an exit strategy if inflation (actual or expected) emerged as a problem in financial markets. The strategy also risks eroding investor confidence if it appears to be motivated by panic about how to keep the economy out of recession.
“More aggressive Fed action could also bring a significant cost in the form of increased tension in global financial markets,” Zandi said. The dollar “has fallen measurably in value vis-à-vis the euro, Japanese yen, and a number of emerging economy currencies. While this is a plus for U.S. trade and growth, it poses a hardship for these other economies.”
Consternation over currency rates was the focus of the world’s top finance ministers at a recent meeting in South Korea.
One Chinese official voiced doubt about Fed policy in a public statement this week.
“Uncontrolled printing of dollars and rising international prices for commodities are causing an imported inflationary ‘shock’ for China and are a key factor behind increasing uncertainty,” trade minister Chen Deming said, according to a state-run newspaper cited by the Associated Press.
Over the past month, as expectations of new Fed easing have grown, global commodity prices have risen. Investors have pushed down the value of the U.S. dollar, perhaps on expectations that the Fed move, designed in part to quell the risk of deflation, will result in worrisome inflation.
At the same time, U.S. stock prices have risen modestly, and long-term U.S. interest rates haven’t changed much.