The Fed’s QE Taper: Downsides and Upsides

Izabella Kaminska over at FT Alphaville recently ran an interesting piece on QE. Her main argument for QE was that it attempted to put the squeeze on rich folks and that might not be bad for an unbalanced economy. Her point is well taken, as I’m sure she knows that downside risks QE has with regards to asset bubbles.

Let’s deal with this first. Kaminska quotes Brad Delong to make the case that such asset bubbles are not turning up. For example, Delong discusses equities about which he says:

A world in which U.S. equities currently have an earnings yield of 6%/year does not appear to be a world in which there is ample risk-bearing capacity going begging in the marketplace. If there were, there might be an argument that the Federal Reserve’s pulling Treasury duration risk out of the marketplace increases the risk of bubbleicious overleverage by feckless risk-lovers. But if there are feckless risk-lovers, why haven’t they bid equities up to more substantial price-earnings multiples? (Emphasis Mine)

Well, as I have argued before, the P/E ratio in the US stock market is being held down, to a large extent, by a surge in corporate profits. This is also what the likes of Robert Shiller are concerned with. These profits have two broad sources: student loans and, more importantly, the federal budget deficit.

These two sources are also what is driving the US economy more generally and while student loans appear to be piling up to the moon — with no thought given to the negative consequences of loans with a ‘no default’ clause burdening the nation’s youth for the rest of their lives — the federal budget deficit continues to go lower and lower. The latest round of cuts, for example, which included a $40bn cut in the highly stimulatory food stamp program are eventually going to be reflected in lower corporate profits.

This fall in corporate profits is then going to feed through to the P/E ratio in the form of lower earnings. Then economists like Delong might start getting itchy about the stock market. All this is already on the cards, as it were, and its only a matter of time before this happens.

Moving on to what effects QE has on growth. Well, with all the taper talk we got a nice experiment in what QE actually does. Almost instantly after Bernanke uttered the ‘T-word’ mortgage rates spiked by a whole percentage point as can be seen in the graph below.

How much of an effect does such a spike have on the economy? Well, first and foremost it lowers debtors’ disposable income by increasing their interest repayments. This can have an effect on the demand generated by said debtors.

The spike would also, it would be presumed, slow the housing market, the recovery in which has been a key component of the US economy so far staying out of recession. This, however, may not be as true as many might think as it was recently found that over half of homes are being purchased with cash.

Yes, rich folks in the US are seeing the lows in the property market as something of an investment opportunity. This is undoubtedly happening, to some extent, because of the low yield QE environment and while I do not currently fear a bubble in the US housing market, such cash purchases do raise serious questions about what type of society the US is becoming with rich and old folks owning lots of houses which they presumably rent to the poor and young, who are likely burdened by student loans on which they cannot default.

So, what is my estimation of QE? It is as good as it is bad. Beyond that it provides something for economists to talk about when the reality on the ground is that one of the fundamental problems in the US economy — that is, horrendously skewed income distribution — is getting ever worse. At the same time the only thing really keeping the whole thing ticking over — from the economy itself, to the earnings in the stock market — that is, the federal budget deficit, is silently fading away. Meanwhile, all one hears in the financial press is nattering over QE.

That, I think, is the true function of QE. It is a distraction for policy wonks, economists and market participants to talk about by the water cooler. And, dear reader, you need not point out that I too have just added my voice to that choir.