Monday, September 17, 2012

A Dallas Fed Paper Doesn't Think the Fed's Policies Are Effective and May Be Making Things Worse

Here is a pretty interesting paper that talks about some of the reasons why quantitative easing doesn't seem to be working.  It also points out how Fed activism seems to have created a cycle where the Fed is created serial bubbles, causing crashes when they pop them which then requires an even greater response.  Yes this is a Fed paper we are talking about :

Conventional thinking is that lower interest rates will encourage households to save less (and consume more) and will encourage companies to invest more. In both cases, spending is brought forward from the future, because the discount rate has been reduced. Even abstracting from the influence of cumulative stock considerations (both real and financial) on spending this conventional thinking can be challenged in a number of ways.


A consideration that applies to both household and company spending is the message given by ultra easy monetary policy. To the extent that such measures are unprecedented, indeed smacking of desperation, they could actually depress confidence and the will to spend.



The distributional (income) implications of interest rate changes for aggregate household spending also receive too little attention. Very low rates imply less household disposable income for creditors and more disposable income for debtors. Should the marginal propensity to consume of creditors (say older, credit constrained people living off accumulated assets) exceed that of debtors, the net effect of redistribution could be to lower household spending rather than raise it.



 Lower interest rates cannot generate "wealth", if an increase in wealth is appropriately defined as the capacity to have a higher future standard of living. From this perspective, higher equity prices constitute wealth only if based on higher expected productivity and higher future earnings. This could be a byproduct of lower interest rates stimulating spending, but this is simply to assume the hypothesis meant to be under test. As for higher house prices raising future living standards, the argument ignores the higher future cost of living in a house. Rather, what higher house prices do produce is more collateral against which loans can be taken out to sustain spending. In this case, however, the loan must be repaid at the cost of future consumption. No "wealth" has in fact been created. In any event, as noted above, house prices in many countries have continued to fall despite lower policy rates. This implies that the need for "payback" can no longer be avoided by still further borrowing.



 Ramaswamy (2012) presents a chilling quantitative analysis of the effects of interest rate changes on public pension funds and defined benefit funds. The essence of the argument is that lower interest rates reduce the asset revenues of pension funds and raise the present value of future liabilities. Funding shortfalls eventually have to be made up by the sponsoring company, reducing profits and funds available for investment.


A recent report by the consulting firm Mercer indicates that the 1500 leading companies in the US had a pension deficit of $689 billion as of July 2012; i.e., they are only 70 percent funded. In the UK, the Pension Protection Fund recently estimated that almost 85 percent of defined benefit plans were underfunded, with a cumulative shortfall of over $400 billion. Moreover, proposed changes to pension rules, in countries using IFRS accounting standards, seem likely to make the impact of low rates on companies with such pension funds significantly worse.


To summarize, there are significant grounds for believing that the various channels through which monetary policy might normally operate are at least partially blocked. Moreover, there are also grounds for belief that neither household nor corporate spending would react as vigorously as in the past, even if the traditional transmission channels were functioning properly.



From the perspective of this hypothesis, monetary easing after the 1987 stock market crash contributed to the world wide property boom of the late 1980's. After it crashed in turn, the subsequent easing of policy in the AME's led to massive capital inflows into SEA contributing to the subsequent Asian crisis in 1997. This crisis was used as justification for a failure to raise policy rates, in the United States at least, which set the scene for the excessive leverage employed by LTCM and its subsequent demise in 1998. The lowering of policy rates in response, even though the unemployment rate in the AME's seemed unusually low, led to the stock market bubble that burst in 2000. Again, vigorous monetary easing resulted, as described above, which led to a worldwide housing boom. This boom peaked in 2007 in a number of AME's, seriously damaging their banking systems as well. However, in other AME's, the house price boom continues along with still rising and often record household debt ratios. This latter phenomena, as well as other signs of rising inflation and other credit driven imbalances in EME's, reflects the easy monetary policies followed worldwide in the aftermath of the crisis.

By mitigating the purging of malinvestments in successive cycles, monetary easing thus raised the likelihood of an eventual downturn that would be much more severe than a normal one.

Moreover, the bursting of each of these successive bubbles led to an ever more aggressive monetary policy response.

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