September 10, 2012 8:14 pm
For true stimulus, Fed should drop QE3
Unsatisfied by the pace of the US recovery, the Federal Reserve seems set to launch a new round of quantitative easing. Well, the Fed can print all the money it wants – but it cannot dictate where it will go.
The first two rounds of quantitative easing fuelled a commodity bubble, increased income inequality and set a bad example for the rest of the world. During the 16 months of round one, up to March 2010, the CRB commodity price index rose 36 per cent, while food prices rose 20 per cent and oil prices surged 59 per cent. During round two, in the eight months up to June last year, the CRB rose 10 per cent, with food up 15 per cent, while oil prices rose a further 30 per cent.
This link neuters monetary policy makers, because rising commodity prices negate the stimulative impact of looser credit. When the price of oil hits $120 a barrel, consumer spending on energy reaches 6 per cent of total worldwide income and starts to cut into spending on other goods. Oil prices breached $120 a barrel in mid-2008, mid-2010 and mid-2011, and the global economy lost momentum each time. In effect, oil prices act as interest rates used to, discouraging consumption even when the Fed is trying to encourage spending. Estimates suggest that in the US, every $10 increase in the price of oil shaves 0.3 per cent from gross domestic product and instead adds 0.3 per cent to inflation. The Fed is keen to avoid deflation and to keep inflation at 2 per cent, but if it reaches that goal by means of commodity price inflation it will be something of a pyrrhic victory.
Worse, the Fed’s campaign is increasing inequality. The hope is that quantitative easing will drive up stock prices, making consumers feel richer and spend more. But this glow is felt mainly by families in the top 10 per cent of incomes, because they own 75 per cent of all stocks. Meanwhile, the poor are hit hardest by rising commodity prices: families in the bottom 20 per cent of incomes spend 8 per cent of their income on petrol and 30 per cent on food, while the top 20 per cent spend just 2 per cent on petrol and 5 per cent on food. This link between monetary easing and inequality is a byproduct of the new liquidity link between stock prices and oil prices.
As the Fed started to hint at QE3 a few weeks ago, oil and food prices started to rally again. Fed officials used to cite strong demand in the developing world to explain commodity price inflation, but with growth slowing in emerging markets, supply-and-demand dynamics cannot explain this rally. Trading fuelled by easy money can, however: actively traded commodities such as gold, copper and coal are selling at prices 20-65 per cent higher than the marginal cost of production. Prices of less actively traded commodities, such as steel and iron ore, are falling.
The Fed is trying to defy the course of history. As the International Monetary Fund has shown, output typically declines by 10 per cent relative to trend in the seven years following a major financial crisis and the US economy is so far following that path. The Fed wants a quicker recovery but so far it has merely produced a rise in commodity prices that hurts the US and major emerging markets, where food and energy constitute a larger share of consumer spending.
Following the Fed’s lead, China aggressively eased monetary policy after the crisis in 2008, creating a housing bubble. In the past five years, China’s ratio of bank credit to GDP rose 65 per cent, a bigger rise than in other major credit booms, including those of the US in 2007 and Japan in 1990. Beijing is backing away from more stimulus, fearful that it will further fuel inflation.
Meanwhile, the US is pushing a third round of quantitative easing, which could be more counterproductive than the first two, since oil and food prices are now dangerously close to levels that have acted as a tipping point for the global economy in the past. Some economists trace oil and food prices to non-monetary factors such as geopolitical tensions in the Middle East and drought conditions. Maybe. But at this point, abandoning QE3 would do more good than pushing it, because dropping it would lead to a fall in oil and food prices. That would be equivalent to a significant tax cut for the middle class and would act as a true stimulus for the global economy.
The writer is head of emerging markets and global macro at Morgan Stanley Investment Management and author of ‘Breakout Nations: In Pursuit of the Next Economic Miracles’ (Allen Lane 2012)
Copyright The Financial Times Limited 2012.