Caution, Fed laying trap ahead

That is certainly the case in the US today. QE may have been a resounding success in some ways - namely, arresting the riskiest phase of the crisis. But it did little to revive household consumption, which accounts for about 70 percent of the US economy. In fact, since early 2008, annualized growth in real consumer expenditure has averaged a mere 1.3 percent - the most anemic period of consumption growth on record.

This is corroborated by a glaring shortfall in the "GDP dividend" from Fed liquidity injections. Though $3.6 trillion of incremental liquidity has been added to the Fed's balance sheet since late 2008, nominal GDP was up by just $2.5 trillion from the third quarter of 2008 to the second quarter of this year. As John Maynard Keynes famously said after the Great Depression, when an economy is locked in a "liquidity trap", with low interest rates unable to induce investment or consumption, attempting to use monetary policy to spur demand is like pushing on a string.

This approach also has serious consequences for financial markets. Having more than doubled since its crisis-induced trough, the US equity market - not to mention its amply rewarded upper-income shareholders - has been the principal beneficiary of the Fed's unconventional policy gambit. The same is true for a variety of once risky fixed-income instruments - from high-yield corporate "junk" bonds to sovereign debt in crisis-torn Europe.

The operative view in central banking circles has been that the so-called "wealth effect" - when asset appreciation spurs real economic activity - would square the circle for a lagging post-crisis recovery. The persistently anemic recovery and its attendant headwinds in the US labor market belie this assumption.

Nonetheless, the Fed remains fixated on feedback from financial markets - and thus ensnared in a potentially deadly trap. Fearful of market disruptions, the Fed has opted for a slow-motion exit from QE. By splitting hairs over the meaning of the words "considerable time" in describing the expected timeline for policy normalization, current Fed Chairman Janet Yellen is falling into the same trap. Such a fruitless debate borrows a page from the Bernanke-Greenspan incremental normalization script of 2004-2006. Sadly, we know all too well how that story ended.

The author is a faculty member at Yale University and former chairman of Morgan Stanley Asia, and has the book, Unbalanced: The Codependency of America and China, to his credit.

Project Syndicate