Was the Fed Forced to Go Wrong With Quantitative Easing?

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Did Congress force the Federal Reserve to go wrong with the bond-buying program known as quantitative easing? The cost of quantitative easing according to strategists such as Athanasios Vamvakidis at Bank of America could be the Federal Reserve’s unconventional monetary policy and its relationship with financial markets. He argues “excessive reliance on unconventional monetary policy” can create side effects, many of which are now being felt in markets.

During quantitative easing, markets started reacting positively to bad news. Bad news became good news for asset prices when markets expected additional QE by the Fed. Asset prices diverged from fundamentals. Markets traded the Fed instead of economic reality. This was not sustainable. Vamvakidis believes the market’s strong reaction to the Fed’s announcement in 2013, that it planned to “taper” was one sign that QE had already gone wrong.

The Fed “taper tantrum” could have been the first sign. The Second, could have been the emerging markets sell-off which started mid-2014. QE tapering was ending and the market started pricing Fed tightening, a sell off that deepened this year.

Vamvakidis doesn’t believe QE should have never happened. He realizes Fed policy helped the U.S. prevent another great depression that could have become a consequence of the financial crisis. But, he does not believe bond-buying should be the first choice when things go wrong in the economy. He calls QE “a necessity,” but is skeptical of the Fed’s subsequent rounds of QE2 and QE3. He notes, that despite the continued expansion of balance sheets at a number of central banks around the world, monetary policy conditions have tightened and liquidity has fallen.

What Vamvakidis does not mention is that the Fed was never meant to go it alone. One of arm of government can rarely solve the nation’s ills. A response on the fiscal side by Congress has been sorely lacking. It does not help that Congress brought the U.S. government to the brink of default more than once. The Fed Should not have been forced to create unconventional tools because congress could not agree on how to respond. Even now, congressional refusal to cross partisan lines and agree to a budget undermines further recovery.

We find ourselves in a situation where risk assets have sold off expecting the Fed to tighten. It is beginning to affect the real economy. The Fed is not tightening as a result. However, postponing Fed tightening does not necessarily increase demand for risk assets. This is a new paradigm where bad news is bad news. When combined with gridlock on the fiscal side, the path to an economy that operates on normal principals may not be smooth.