London, 8 August 2011: Reuters

Clamour from Wall Street for another round of quantitative easing has been building for weeks and is set to become intense as investors panic at the threat of a double dip and stock markets plunge. But it is not clear the last round of large-scale asset purchases (LSAP) resulted in any lasting improvement to the economy. By contributing to a rise in oil and food prices it may actually have done more harm than good.

While the Fed has successfully manipulated financial variables such as bond and equity prices, produced an increase in inflation, and raised inflation expectations, it has failed to generate sustained improvement in the real economy through hiring and a pick-up in wages.

Without jobs, income and consumer spending, the recovery has run out of momentum and asset values have started to fall back to earth. There is no reason to think repeating the experiment, perhaps on an even larger or more radical scale, would produce any better results in future.

A BOLD EXPERIMENT

Policymakers' objectives for quantitative easing (QE) and the transmission mechanisms by which it was meant to achieve them have seemed confused and to shift over time. Speaking in February, New York Fed Executive Vice President Brian Sack gave perhaps the definitive explanation.

Sack argued the LSAP programme was "intended to influence financial conditions in a manner that would support the economic recovery and return employment and inflation, over time, to levels consistent with the [Fed's] objectives".

"One way that this might occur is through a portfolio balance channel ... Removing duration risk from the market would tend to keep longer-term real interest rates lower than they otherwise would be and would encourage investors to move into other types of assets, thereby making broader financial conditions more accommodative," according to Sack.

Speaking around the same time, St Louis Fed President James Bullard concluded QE had been a success and illustrated his argument with a deck of slides showing the impact on equity prices, break-even rates, the exchange rate and equity market volatility. In an update at the end of June, Bullard continued to insist easing had been successful.

ENDS IN FAILURE

But this confidence was premature. In its own terms, QE has been a failure. The attached chart is adapted from Bullard's slide presentations in February and June, examining the impact of QE on various financial indicators. Performance on all these measures has deteriorated significantly since April

QE Impact Graphic

QE has not promoted a sustained improvement in financial conditions, let alone created a firm basis for a selfsustaining recovery. Increases in the value of risk assets have not translated into jobs, wages and consumer spending. Stock market gains have proved ephemeral. Forward looking markets focused on the prospect of an accelerating recovery, but as that failed to materialise have given up their gains. Financial markets cannot long prosper when the real economy remains stuck in the doldrums.

On the inflation front, expectations have risen because QE has been associated with sharp price increases for food, fuel and clothing. But because wages have not increased at the same time, price rises have actually dampened consumer spending and contributed to the sharp slowdown in growth over the first six months and especially in the second quarter.

Even the "improvement" in expected inflation could prove fleeting. With growth stalling, the latest round of surveys show an abrupt fall in the number of rising prices. As the outlook grows grimmer, concerns about deflation will reemerge. Break-evens have already fallen by around a quarter since April and will likely decline further if fears of a double dip take hold

ISM Commodity Balance Graphic

In public, Fed officials deny QE is responsible for triggering the sharp rise in the price of oil and other commodities. They insist the coincidence of QE with the first leg of a sharp run up in oil prices between September 2010 and January 2011 (before the Arab Revolt) is not evidence of causation, and prices have been driven by fundamental factors rather than investment flows.

But Fed officials have noted the run up in energy prices was one the primary causes of the "soft patch" the U.S. economy hit in April, and are anxious that oil and other raw materials prices stabilise or fall.

RUNNING OUT OF OPTIONS

Speaking at his press conference in June, Fed Chairman Ben Bernanke appeared unenthusiastic about the possibility of further intervention, unsure of the consequences and fearful about the possible side effects. Fed interventions have been prodigious, but officials admit the results have been modest. The Fed balance sheet is already enormous. Providing ever-larger amounts of stimulus to achieve such meagre results is neither sensible nor sustainable.

Responding to a question from Reuters, Bernanke promised "We'll continue to look at the outlook and act ... We do have a number of ways of acting." But he warned "all of these things are somewhat untested. They have their own costs." It is not clear what purpose any of these interventions would serve or why they would be any more lastingly effective than the last round.

Bernanke could promise to hold down short-term interest rates for longer in a bid to drive down yields on longer dated securities. But yields are already exceptionally low, and it has not stimulated an investment boom, hiring, or a recovery in the housing market.

Bernanke could try to pull down the cost of corporate borrowing and hope it stimulates more investment and hiring. But again corporations are already flush with cash, and at least the larger ones have access to cheap credit. It has not prompted them to hire more workers or boost wages faster. Bernanke could try to drive real interest rates lower by stoking inflation and fears of future inflation. But with rising food and fuel prices already weighing heavily on consumers, raising inflation and inflation expectations would probably do more harm than good.

THE ECONOMIST'S WORLD

The problem is that the Fed can only generate the "wrong" sort of inflation in commodity and asset prices and not the "right" sort of inflation (in wage rates) that might erode the burden of household debts and give consumers and through them businesses more confidence about the future.

Observers, led by Professor Paul Krugman at the New York Times, have argued liquidity injections and rising commodity prices do not threaten a repeat of the stagflation and wage-price spirals of the 1970s because wages are not rising. But that is the heart of the problem. Without wage rises, consumer confidence and the credit-creation process has stalled, and rising prices are recessionary.

The last three decades have seen a powerful consensus emerge among policymakers centred around trade liberalisation, lightly regulated financial markets, deregulated labour markets, and dismantling many of the traditional pillars of the social safety net and many of the institutions that gave wage-negotiators bargaining power.

It is a consensus which reflects and has been championed by the Economist magazine -- the increasingly influential house journal of the global business and policymaking elite. But for all its benefits, the world the Economist has championed has proved to be short-termist, dominated by finance rather than production, and serially unstable, plagued by repeated financial crises at increasingly short intervals and each larger than the last.

It has tilted the balance from workers and households in the lower quartiles of the income distribution in favour of businesses able to wield pricing power. Booming profits, soaring prices and stagnating wages are two sides of the same coin.

While policymakers agree the balance must shift back from profits to wages to restart growth, it is not easy to see how that could be achieved within the current framework.

In the world the Economist wrought, the Fed's increasingly creative stimulus packages cannot generate hiring or wage gains. Right now Bernanke would probably welcome a bit of wage-price spiral, but he has no way to spark one.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.