Thursday, February 24, 2011

Monetary easing and the need for macroprudential monitoring

I had previously thought QE’s main goal was to help inflate away debt. But by its very nature, it is also designed to inflate the price of assets. I had thought proponents wanted monetary easing because it helps ensure there is adequate money going around to address the needs of illiquid people/entities. But it seems proponents advocate it just as much to increase inflation expectations.

I had previously thought of monetary easing in defensive terms, and even then, I had thought it to be destructive because of the way it encouraged asset speculation as a side effect. But now I see that asset speculation is in fact a primary transmission mechanism of monetary easing. A central bank undertaking it wants real assets to appreciate because the increase in assets makes people feel they are wealthier, and therefore more open towards purchasing more. A rising monetary base increases inflation expectations among the people, such that they begin to purchase things now rather than later.

Noble though monetary easing's objective is in alleviating the economy, realizing that the ugly side effect of blowing asset bubbles is in fact front and center in its transmission mechanism does color my perspective on it. Monetary easing then is akin to waving the red cape to the bull, to induce the bull to attack you. Given this, what exactly are your defensive mechanisms against a charging bull?

If a Fed policy were to encourage the rise of various asset classes to effect an economic rebound, it should at least acknowledge and monitor the rise of unsustainable bubbles. A pricking could put the economy on worse footing then from where it started.What exactly are the monetary experts’ recommendations to ensure that such a pricking does not destroy the economy? The only surefire way I could think of preventing a meltdown is to make the easing permanent.

But making it permanent means that if the easing overshoots, the increasing inflation might be permanent and unstoppable. An unstoppable inflation eventually feeds onto a feedback loop of ever increasing inflationary expectations, which could escalate into further inflation*, asset appreciation escalating into even more asset appreciation.

The transmission channel is not limited just to the regular banking system, and QE could make the parallel shadow banking system become powerful once more, and we know that the shadow banks are not constrained by regulation or strict capital requirements. A parallel banking system actually accumulates its capital from chasing a market as it rises to the top, and this feedback loop of increasing asset prices will encourage more shadow players to buy more assets as they inch up, thereby reinforcing the convictions that they started out with. This mechanism also includes the general public, primarily via pensions and investment funds, which are major transmission channels of the wealth effect, via asset appreciation**

I began to doubt the notion, about a year ago, that central banks could induce asset bubbles. But now I have erased all doubt. Nothing can stop a determined central banker, one with the power of fiat, and a market that knows how to play along and game the game.

Since monetary easing's stimulative effects are transmitted via increasing inflation expectations and asset appreciation, it is utter irresponsibility and pure madness to embark on it without an adequate macroprudential framework. And constantly subjecting all financial entities to macroprudential measures, and using macroprudential tools whenever necessary, and constantly monitoring various assets for potential bubbles.

* Even if not so much in core inflation, but so much in consumer staples inflation
** Thanks to Andy Harless for reminding me that QE need not be limited or targeted only to banks


Greg said...

As Cullen Roche at Pragmatic Capitalism has said, QE works by encouraging a casino type mentality. Just bet on asset prices and you can get rich (wealth affect). Problem is if everyone with extra capital is doing this no one is investing into truly productive ventures and the real economy is deprived of investment.

Ben assumes if you feel rich enough youll start taking risks into productive ventures....... but why should you if you can just keep getting richer gambling!!

Rogue Economist said...

If you know that the Fed can easily save your wrong investment choices in asset bubbles by further easing, whereas your investment in a business that needs to sell actual products is not easily saved by such easing, it's really a no-brainer where you put your money in.

The Arthurian said...

Finance is a black hole from which nothing escapes.

Policy keeps doing things to improve conditions for finance, because policymakers think we need credit for growth.

Ford was already in the 1990s making more money by financing cars than making cars.

To look at where we ended up is fine; but to see where we ended up as the problem, is wrong.