Updated Aug. 9, 9pm EDT
The Federal Reserve’s much awaited statement following its August meeting offered some solace to jittery investors. The FOMC said it would likely keep interest rates steady for the next two years, which bolstered the market after an initial negative reaction. But it committed nothing in the way of new funding or bond purchases for now. The good news is, that may actually be for the best.
Investors have been clamoring for another round of quantitative easing to juice up market confidence. But QE isn’t a cure-all for what ails the economy, and here are a few reasons why:
The economy is in a different spot now than when the Fed unleashed its last round of QE. Last year the big fear plaguing markets was about deflation. That is, if prices for goods and services spiraled downwards because of weak demand, companies making less money because of selling their wares for less would have to lay off workers, further weakening demand. And so would begin a vicious cycle. To its credit, QE2, despite its many drawbacks, seems to have put out that fire. Inflation has risen roughly 2% this year.
Now the economy is facing other problems. The biggest of those is lackluster growth. Of course, America’s debt ceiling debacle and its S&P downgrade added fuel to the fire, but the fear and uncertainty were already there. Growth forecasts for the U.S. have continued to head down, to an annualized rate of 2.3% in the second quarter from an expected 3.1%. And China, the world’s growth engine, is in no shape to pick up the slack. Its industrial growth slowed in July amid rising inflation. Meanwhile, in the troubled eurozone, even the strongest economies — Germany and France — are slowing to a near standstill. All this has inspired a cash bath for investors around the globe, sucking trillions of dollars out of company equity and driving global markets into the gutter. World markets have hit bear market territory, falling 20 percent since May.
Another round of QE might be a welcome distraction from these realities, but the problems would only resurface. In fact, QE3 might only make things worse by inflating stock prices beyond the economy’s real strength. Nobel laureate Michael Spence explains on Project Syndicate:
The resetting of asset values in line with realistic growth prospects is probably not a bad outcome, though it will add to the demand shortfall in the short run. But uncertainty, lack of confidence, and policy paralysis or gridlock could easily cause value destruction to overshoot, inflicting extensive damage on all parts of the global economy.
With interest rates already low and companies hoarding cash, another round of QE wouldn’t do much to inspire lending and spending, which is the key to spurring jobs and growth. And if, as Spence notes, another QE-inspired stock bubble burst, the effects could cripple investor confidence. As I’ve said before, the quickest route to job creation is to revive the small and medium-sized banks that lend to small businesses, along with the homeowners paralyzed by mortgage debt. To do this, Nouriel Roubini says we need an orderly debt restructuring. Others are pushing for payroll-tax relief and more help for the unemployed.
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But then, all eyes keep turning back to the Fed, because the political will in Washington seems all but dead. And yet, as I see it, that’s one more reason for the Fed to stand back. Its temporary jolts to the market have only enabled policymakers in Washington to stall on job-creating policies. In that sense, the Fed’s statement struck the right tone by upping the stakes for Washington.