Saturday, September 19, 2015

The Effect Of QE On Inflation Expectations And Stock Prices

Roger Farmer provides his answer to John Cochrane's argument against Fed intervention in a market economy that is intrinsically stable according to the Chicago School.  He provides two graphs which show the impact of QE on the Fed balance sheet and its relationship to expected inflation and the S&P 500.  Expected inflation had reached -4% prior to the Fed's QE program.  The Fed's purchase of $1.3 trillion of mortgage backed securities reversed the deflationary trend, and brought the inflation rate closer to its 2% target.  It also reversed the downward spiral in the stock market and brought it closer to the level that existed prior to the financial crisis.

Farmer takes the position that the financial system does an inefficient job of allocating capital and that the real economy is linked to the value of asset prices.  Many economists believe that the capital market is efficient, and that the real economy is not affected by asset prices.  Its easy to see why economists from the Chicago School which believes that asset markets are efficient, and that the real economy is not affected by asset prices,  would have a problem with Farmer's data.  QE had a major impact on inflation and asset prices.  It may have prevented another Great Recession. Since the impact of QE on the economy cannot be explained by Chicago School theory, Cochrane rejects the idea that QE was responsible for the reversing deflation and the rapid decline in asset prices.

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