"Quantitative easing fits profile in American rebound mystery"
Op-Ed, The Age
March 2, 2011
Author: Martin Feldstein, George F. Baker Professor of Economics at Harvard University
There is no doubt the American economy rallied strongly at the end of last year. But how much of that was due to the US Federal Reserve's temporary policy of so-called "quantitative easing"? And what does the answer mean for the US economy this year?
Until the fourth quarter of last year, the US economic recovery that began in the northern summer of 2009 was decidedly anaemic. Annual GDP growth in the first three quarters of 2010 averaged only about 2.6 per cent - and most of that was just inventory building. Without the inventory investment, the growth rate of final sales averaged less than 1 per cent.
But the fourth quarter was very different. Annual GDP rose by 3.2 per cent and growth of final sales jumped to a remarkable 7.1 per cent year-on-year rate. True, much of that was due to a sharp decline in imports, but even the growth rate of final sales to domestic purchasers rose at a healthy 3.4 per cent pace.
The driver of the increase in final sales was a boost in consumer spending. Real personal consumer spending grew at a robust 4.4 per cent as spending on consumer durables soared by 21 per cent. That meant the acceleration of growth in consumer spending accounted for nearly 100 per cent of the GDP increase, with the rise in durable spending accounting for almost half that increase. But the rise in consumer spending was not due to higher employment or faster income growth. Instead, it reflected a fall in the personal savings rate. Household savings had risen from less than 2 per cent of after-tax incomes in 2007 to 6.3 per cent in the northern spring last year. But then the savings rate fell by a full percentage point, reaching 5.3 per cent in December.
A likely reason for the fall and resulting rise in consumer spending was the sharp increase in the sharemarket, which rose by 15 per cent between August and the end of the year. That, of course, is what the Fed had been hoping for.
At the annual Fed conference in August, Fed chairman Ben Bernanke said that he was considering a new round of quantitative easing (dubbed QE2), in which the Fed would buy a substantial volume of long-term Treasury bonds, thereby inducing bondholders to shift their wealth into equities. The resulting rise in equity prices would increase household wealth, providing a boost to consumer spending.
To be sure, there is no proof that QE2 led to the sharemarket rise, or that the sharemarket rise caused the increase in consumer spending. But the timing of the market rise, and the lack of any other reason for a sharp rise in consumer spending, makes that chain of events look very plausible.
The magnitude of the relationship between the sharemarket rise and the jump in consumer spending also fits the data. Since share ownership (including mutual funds) of American households totals about $US17 trillion, a 15 per cent rise in share prices increased household wealth by about $US2.5 trillion. The past relationship between wealth and consumer spending implies that each $US100 of additional wealth raises consumer spending by about $US4, so $US2.5 trillion of additional wealth would raise consumer spending by roughly $US100 billion.
That figure matches closely the fall in household savings and the resulting increase in consumer spending. Since US households' after-tax income is $US11.4 trillion, a 1 percentage-point fall in the savings rate means a decline of savings and a corresponding rise in consumer spending of $US114 billion - close to the rise in consumer spending implied by the increased wealth that resulted from the gain in share prices.
None of this appears to augur well for this year. There is no reason to expect the sharemarket to keep rising at the rapid pace of 2010. Quantitative easing is scheduled to end in June, and the Fed is not expected to continue its massive purchases of Treasury bonds after that.
Without that increase in sharemarket wealth, will the savings rate continue to decline and the pace of consumer spending continue to rise more rapidly than GDP? Will the strong economic growth at the end of 2010 be enough to propel more spending by households and businesses in 2011, even though house prices continue to fall and the labour market remains weak? And does artificial support for the bond market and equities mean that we are looking at asset-price bubbles that may come to an end before the year is over?
Only time will tell. But these are the questions investors and policymakers alike should be asking.
Martin Feldstein, professor of economics at Harvard University, was chairman of Ronald Reagan's Council of Economic Advisers, and is former president of the National Bureau for Economic Research. Source: Project Syndicate.
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