David Einhorn: The Fed's Policy Is Backfiring

David Einhorn
David Einhorn

Count David Einhorn as a skeptic when it comes to quantitative easing.

A recent letter from Einhorn's Greenlight Capitol argues that fear of inflation is causing investors to sell bonds and avoid housing, leading both to slump.

Inflation fears are also driving up commodities prices, the letter argues.

From Greenlight's letter:

Here in the United States, our fears that quantitative easing would be a net harm to economic activity appear to be playing out. The prices of things people actually pay for including food, energy and healthcare continue to go up at an accelerated pace ...

While Chairman Bernanke claims that quantitative easing has succeeded in raising stock prices, it seems that equities have gone up for the opposite reason he proposed. According to Mr. Bernanke, Federal Reserve purchases of government bonds were supposed to raise their price so that they would be less attractive than other investments, including housing and equities. Investors would note the disparity and “rebalance” their portfolio to buy more houses and stocks, which would appear cheap compared to higher bond prices. This would support the housing recovery and make the equity market rise.

Instead, it appears that in response to quantitative easing, investors now fear inflation and have sold bonds. Interest rates have risen and housing prices have declined further. The housing recovery has faltered, creating another negative wealth effect and putting additional strain on the banking system. The money that the private sector would have lent to the government, had the Federal Reserve not printed the money instead, has gone to other goods, notably commodities and stocks to the extent investors see them as a better inflation hedge than bonds. Though the Federal Reserve has produced “research” that purports to show that quantitative easing has not caused commodity prices to rise, many observers disagree. As the Bank of Japan put it in March, “[I]t is safe to say that globally accommodative monetary conditions are a key driver of the rise in commodity prices by stimulating both physical demand for commodities and investment flows into commodity markets.”

There's a hidden and fascinating claim here. Stocks usually have negative correlation to inflation: when inflation goes up, stocks go down. This pattern, however, contradicts what economists have long argued should happen.

As real assets, stock prices should rise with the prices of other assets. Despite economic theory, however, the negative correlation has persisted. A one percent increase in inflation is historically correlated with a 2.4 percent decline in stock market returns.

Economists have spilled a lot of ink in the past few decades trying to explain why reality doesn't conform to theory. Has this pattern finally been broken? Are markets no longer "underpricing" stocks during inflationary periods?


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