US faces tricky problem thanks to QE

The US Federal Reserve continues to cling to a destabilizing and ineffective strategy. By maintaining its policy of quantitative easing (QE) - which entails monthly purchases of long-term assets worth $85 billion - the Fed is courting an increasingly treacherous endgame at home and abroad.

By now, the global repercussions are clear, falling most acutely on developing economies with large current account deficits - namely, India, Indonesia, Brazil, Turkey and South Africa. These countries benefited the most from QE-induced capital inflows, and they were the first to come under pressure when it looked like the spigot was about to be turned off. When the Fed flinched at its mid-September policy meeting, they enjoyed a sigh-of-relief rally in their currencies and equity markets.

But there is an even more insidious problem brewing on the home front. With its benchmark lending rate zero bound, the Fed has embraced a fundamentally different approach in attempting to guide the US economy. It has shifted its focus from the price of credit to influencing the credit cycle's quantity dimension through the liquidity injections that QE requires. In doing so, the Fed is relying on the "wealth effect" - brought about largely by increasing equity and home prices - as its principal transmission mechanism for stabilization policy. There are serious problems with this approach.