Yanking Bernanke's chain

By MoneyRates.com

Following a disappointing employment report and a pullback in the stock market, by the middle of April some investors and commentators were clamoring for the Federal Reserve to launch into a third round of quantitative easing, or "QE3" as it is popularly known.

The expectation seems to be that any economic or market disappointment should prompt an immediate and automatic response by the Fed -- like yanking on a dog's chain and having it come to heel. However, after two previous rounds of quantitative easing, it's worth asking who is yanking the chain, and whether Ben Bernanke should be held on such a short leash.

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Through-the-looking-glass investors

To understand why there is such vocal support for QE3, it helps to start with a class of people who could be called through-the-looking-glass investors. They seem to exist in a world where up is down and down is up, but there is a reason for that.

Through-the-looking-glass investors are the ones who seem to welcome bad news, in the hope that it will prompt another round of quantitative easing. They are the reason why a negative economic announcement will sometimes be followed by a stock market rally, and by breathless commentators on television waving their arms and exclaiming that QE3 is as good as here.

These people are not -- appearances sometimes to the contrary -- nuts. They just live in the narrow world of stock and bond valuation. Stocks are generally valued on a model in which earnings are the numerator and interest rates are the denominator. In such a model, value can rise either because the numerator (earnings) rises or because the denominator (interest rates) falls. Since it is often easier for the Fed to lower interest rates than for companies to produce earnings gains, these through-the-looking-glass investors are very enthusiastic about the Fed taking action, even if it means a short-term earnings disappointment.

Bond investors live in an even more limited world. Since their numerator is the coupon on the bonds they own, it is essentially fixed in place, and all they can root for is for the denominator (again, interest rates) to fall. So they too are rooting for QE3.

Diminishing returns

The catch is that there are diminishing returns to all of this, and not just for the long-suffering depositors stuck with low interest rates on CDs, savings accounts and money market accounts. As interest rates approach zero, the ability of the Federal Reserve to lower them further naturally diminishes. Plus, history suggests that there will come a time when the Fed may have to raise interest rates to battle inflation.

In short, whether it's QE3, QE4 or QE5, eventually these actions will become like Rocky movies -- the sequels just won't be any good. At that point, even the through-the-looking-glass investors will have to root for actual earnings growth -- something that would benefit stocks, job-seekers and savings accounts all at once.

The original article can be found at Money-Rates.com:Yanking Bernanke's chain