Can QE Cause Market Distortions And Even Bubbles?

by: Cullen Roche

I still get a lot of push-back from people when I claim that QE can cause market participants to do irrational things which can cause prices to react in a manner that might be destabilizing. For instance, Noah Smith says my piece on QE and the credit bubble was filled with "with dubious evidence". First of all, I didn't actually say that I thought credit markets were in a bubble, and if that's the message some people got then let me be clear that I have no idea. What I was trying to say was that QE can cause market distortions that might not be healthy, and that QE is so widely misunderstood that people tend to react irrationally to it.

Now, this view irks economists and really irks efficient market thinkers. Imagine a world where the information everyone is getting is totally wrong and so they react to markets in a way that ends up actually influencing prices in a dramatic manner that is also irrational. This is basically what any market is in my view. The "market" is a place where irrational participants place bets using the best information available. Markets might be quick to respond to all available information, but that doesn't mean the information is good, right or even useful.

Remember when QE2 was rolled out in 2010 and everyone was talking about how the "money printing" was going to cause high inflation? What happened? How did people respond to that? Well, inflation expectations almost doubled in a matter of months from 1.5% on the 10 year break-even to 2.7%. And we got all sorts of crazy reactions from commodity markets. Chinese cotton farmers started hoarding cotton because they were convinced that QE was going to export inflation to China. And some financial firms started hoarding copper inventories to fund various operations. These are things that really happened. And they really influenced prices.

Now, some academics might like to ignore this stuff, but when I see the price of cotton TRIPLE in a 4 month period along with verified reports of massive cotton hoarding then I connect the dots. Did QE play NO ROLE at all in the commodity price increases in 2010/11? Maybe it wasn't the primary driver, but I wouldn't say it played zero role. Unless of course, you can just ignore news reports about key distributors hoarding product….

Since then the cotton bubble has popped and prices are basically back to where they were before QE2. Broader commodity prices have cratered since then and inflation expectations are back to 2.2%. In other words, the market might be digesting this information and coming to the realization that QE isn't inflationary, but that doesn't mean it can't cause distortions in the near-term as irrational market participants try to digest the information.

Personally, I think the evidence is pretty cut and dry that QE has distorting elements. Hell, even Brian Sack, who ran the SOMA desk said one of the main goals of QE was to "keep asset prices higher than they otherwise would be". Do we need more confirmation that QE is actually designed to distort markets? Anyone who doesn't think QE is distorting the market is either not paying attention or still doesn't understand how it works (thereby contributing to the distortion!). Now, that doesn't mean QE is causing bubbles everywhere, or that there are even any bubbles at present, but I find it rather disturbing how some people approach QE in such a blase manner. There are real potential risks (and benefits) to this program. And we shouldn't downplay them without looking at what the program has actually done and what it is intended to do, and how that might influence the future economic environment.