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Is the Federal Reserve Killing Growth?

12:20 PM, Apr 28, 2014 • By MATTHEW SCHOENFELD
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Everybody seems to agree that the U.S. Federal Reserve's quantitative-easing program, which involves buying bonds to lower interest rates, plays a role in spurring economic growth. Folks differ on whether the contribution to growth outweighs the risk of inflation. 

Federal Reserve

Federal Reserve

But what if the Fed's efforts are actually hurting growth, and the feared inflation has already arrived?

QE aims to spur the economy by lowering interest rates, thus forcing investors into riskier assets. In layman’s terms, this means asset inflation: The S&P 500 has nearly tripled since March of 2009, bond yields have tumbled, and real estate is again on the rise. Theoretically, this should be a boon to the economy, as folks spend more when they feel wealthier. However, the wealth distribution in the U.S. has limited the effect on consumer spending. The top 10 percent of the U.S. population holds 75 percent of its wealth, compared to 39 percent in Japan and 46 percent in Italy. The bottom 50 percent holds less than 2 percent. This matters because the more unequal the distribution, the less impact QE has on the real economy: A family whose wealth doubles from $5 million to $10 million will likely spend a lower percentage of their multi-million dollar gain on goods and services than will a family whose wealth doubles from $50,000 to $100,000.

Granted, wealth distribution does not explain how the program actually hurts growth. Per the information above, one would merely assume that QE spurs some growth (likely weighted towards spending on luxury goods), but perhaps not enough to warrant the risks engendered, per the arguments of the QE naysayers. However, there is another piece of the puzzle: QE actually incentivizes Corporate America to hoard cash, which in turn slows the economy.

This is counterintuitive. Lower interest should make corporations more inclined to use the $2 trillion in cash that they’re sitting on. In reality, a booming stock market creates precisely the opposite incentive: With shareholders satisfied, corporate executives are hesitant to rock the boat by making a risky investment or a splashy acquisition. After all, the primary concern of the typical corporate executive is job preservation. They are inherently risk-averse because their return profile is asymmetric: A very ‘good’ year and rising share prices might lead to a bump in salary, while a very ‘bad’ year marked by falling share prices might end a career. If share prices are rising and their continued employment is assured, the executive is incentivized to sit on cash and live to collect another annual paycheck.

But hold on a second; don’t rising equity markets usually result in increased M&A volume? Yes, but typically, the underlying cause of the equity appreciation is a flourishing real economy. The company sells more widgets, its earnings rise, and the value of its future cash flows increase. QE, on the other hand, pushes up markets by lowering the discount rate (essentially the return an investor will accept for a given amount of risk). This puts corporate executives in a bind. On the one hand, they might want to deploy low-return excess cash, but on the other hand, a tepid real economy does not warrant overpaying for artificially inflated assets. As we’ve seen, the result is a glut of cash on corporate balance sheets and a slowed economy. Not surprisingly, the last time companies’ hoarded cash with such gusto was in 1975-1976; it was a period marked by a booming stock market and a tepid real economy.

At this point, one might say “Okay, so QE may not have helped growth, but it hasn’t caused inflation!” In response, I would direct you to the IMF’s World Economic Outlook: “It would appear that within a broader monetary policy framework—one in which measures of (asset) transaction prices were used as complementary indicators along with standard inflation indicators...the persistence of growth in money and credit in excess of nominal GDP growth would have suggested that inflationary pressures were building. The need for an adjustment, however, was not recognized until the process of debt accumulation and asset price inflation had reached a critical stage.” 

Asserting that inflation is in check because consumer prices are flat is as logically incomplete as assuming that the economy is in good health because the stock market is up. When inflated asset prices normalize, the fallout will be no less nefarious than that engendered by high conventional inflation. In this vein, it is perhaps worth noting another detail about the IMF Outlook excerpt above: It was written in 1993, as part of a retrospective on the inflation and eventual collapse of Japan’s asset bubble during the prior decade.

Matthew Schoenfeld is a John M. Olin Law & Economics Fellow, and with former Treasury Secretary Lawrence H. Summers co-authored ‘The G-20 in Retrospect and Prospect’ for the 2012 G-20 Summit. He was named to Forbes 2014 ’30 Under 30,’ a list of the top 30 individuals in the financial world younger than thirty years of age.


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