QE2 Winners and Losers

How the Fed’s stimulus maneuver helped the rich and screwed the poor.

Ben Bernanke

Since the onset of the 2008 financial crisis the Federal Reserve has twice attempted to stimulate economic growth through a somewhat unorthodox maneuver called quantitative easing, wherein the Fed buys back Treasury bonds from big banks. When Fed chairman Ben Bernanke last year announced the $600 billion second round of quantitative easing (which within the finance world goes by the nautical-sounding nickname “QE2”), he warned that it might have some unanticipated consequences. “We do not have very precise knowledge of the quantitative effect of changes in our holdings [of Treasuries] on financial conditions,” he said. One of these side effects turns out to be that, at least in the short term, the rich got richer and the poor got poorer.

QE2, which ended last month, began on Aug. 27, 2010, when Bernanke announced it in a speech delivered in Jackson Hole, Wyo. In QE1 the Fed, starting in November 2008, had bought more than $1 trillion of both mortgage-backed securities and Treasuries. That helped loosen credit to both corporations and households. QE1 is generally thought a success. (We had a recession, but we could have had a depression.) QE2, on the other hand, was immediately controversial. It wasn’t clear what yet more purchases would accomplish, and many people worried it would send commodity prices into the stratosphere. But the Fed was more worried that the U.S. economy was headed for Japanese-style deflation, and resolved to ward it off.

So here we are, just shy of a year later. If the Fed’s major goal was preventing deflation, then QE2 has succeeded (with the caveat that we don’t know what would have happened without QE2). One useful way to measure inflation, according to Nomura strategist Paul Sheard, is by the rate that the markets expect in five years. Bernanke said he was worried about any reading below 2 percent. The market-expected rate, which was down to 2.02 percent last August, has risen to 2.6 percent. Mission accomplished. Deflation was averted.

But there are some other things that happened during the past year:

1) Stocks soared. From Bernanke’s speech through the end of June 2011, the Dow Jones Industrial Average increased almost 25 percent.

2) Speculative assets ranging from Chinese dotcoms to social networking start-ups went crazy.

3) Just as skeptics feared, commodities ranging from oil to silver to cotton to food have also seen dramatic increases in price. For instance, the Reuters/Jefferies CRB index, which is designed to track global commodities markets, is up more 25 percent since Bernanke announced QE2.

Economists debate how many of these changes are attributable to QE2. (The same caveat about crediting QE2 with reducing the risk of deflation applies here, too.) It could be that these price spikes have more to do with strong growth in developing countries and supply problems that were exacerbated by the tsunami in Japan. But to traders, who don’t have as nuanced a worldview as economists, it’s pretty clear what happened. Bernanke’s launching of QE2 was a signal that a great way to make money would be to buy commodities, either as a speculative bet or as a hedge against inflation. This became a classic momentum trade. Prices rose, people piled in, prices rose more, more people piled in.

The powers that be at the Fed anticipated that stock prices would go higher. They wanted that to happen; the idea was that everyone would benefit from a rising stock market. “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending,” Bernanke wrote in an op-ed in the Washington Post last fall. “Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

That’s where the inequality problem arises. It’s richer households that predominantly own stocks. According to a recent working paper by New York University Professor Edward Wolff, the top 10 percent of Americans own more than 80 percent of stocks and mutual funds. Meanwhile, rising commodity prices whack people lower down the income scale. Soaring food prices are a particular concern in emerging markets, where people may spend more than one-quarter of their income on food, and where price changes can have life-or-death consequences. Rising food prices are also a concern here in the U.S. Hedge-fund manager David Pesikoff noted in a recent letter that U.S. households with less than $40,000 in income—about 40 percent of us—spend about one-fifth of their income on food. That, Pesikoff notes, puts America’s lower-income population on par with Bulgaria. (Rising gas prices, for which QE2 might also bear some blame, have socked poorer households as well.)

The other half of the story of QE2 is bond yields. QE2 was supposed to push down interest rates, thereby making it cheaper to borrow. That did happen with shorter-term debt. But it was supposed to push down longer-term rates, too. Bernanke, August 2010: “Lower mortgage rates will make housing more affordable and allow more homeowners to refinance.” That didn’t happen. The interest rate on the benchmark 10-year Treasury, which was 2.49 percent on Aug. 26, is now above 3 percent. That explains why the cost of a long-term mortgage, as measured by the yield on Fannie Mae’s 30-year securities, has also nosed upward. (Granted, mortgage rates are still pretty low from a historical standpoint.)

The upshot of this is that anybody who borrowed money for a short length of time—like hedge funds and banks—benefitted. Hedge funds that used borrowed short-term money to make big bets on rising commodity prices made fortunes! But anybody who wanted to borrow for a long time—say, families seeking a 30-year mortgage—lost out. Homeowners didn’t fare so well, either; prices fell some 7 percent after the launch of QE2, according to the Case-Shiller index. David Zervos, the head of global fixed income strategy at Jefferies, wrote in a recent note that QE2 “did not help the 70 percent of the economy we call households.” He continued: “The Fed has only fixed one part of the economy, leaving the household sector out to dry. … [U]ntil mom and pop get the same form of liability funding relief that our banking corporate sectors received, the recovery will be annoyingly slow and bumpy.”

Last but most definitely not least is unemployment. Bernanke cited the “heavy costs of unemployment” as a reason to embark on QE2, and wrote that “there is scope for monetary policy to support further gains in employment without risking economic overheating.” But it’s hard to argue at this point that QE2 has made much difference: The unemployment rate has dropped only a smidgen, from 9.6 percent to 9.1 percent. Perhaps the truest words in Bernanke’s Jackson Hole speech were something else he said: “Central bankers alone cannot solve the world’s economic problems.”

If you try to look beyond the short term, there’s a lot that could change. On the plus side, commodity prices are coming down, perhaps because hedge funds are anticipating that the trade is over. On the negative side, according to the Wall Street Journal, the Fed has bought about 85 percent of the net Treasury issuance over the past eight months, which creates a great deal of uncertainty about who’s going to buy our debt now. Growth is slowing, and there are some worries that the economy may tip over into another recession. If that happens, perhaps the worst legacy of QE2 is that the Fed, with its swollen balance sheet, might find itself at a loss as to how to get us out. Under those circumstances, a Fed that’s played all its cards would be bad for rich and poor alike.