One Strike for the Evans Rule

Note: I’m trying to tentatively oodle and sketch my thoughts here. Forgive idiocy. 

There’s no doubt that tight money in Europe is crippling its economy. But today’s job report should make you think twice about QE, at least under the Evans Rule. Soon after we saw the numbers, DJIA soared by over 165 points in just a few hours. Here’s the problem, markets are responding to a bad, not good, report.

When the Evans rule is contingent on unemployment rate, rather than job creation, the flatline since May has eased investor worries about any “tapering” of bond purchases. We should see Treasury yields fall within the next few days. This is counterintuitive, if the Evans rule worked correctly: meek aggregate demand should chill the markets (or at least not cause them to jump in joy).

One interpretation of these results is the so-called “wealth effect” of quantitative easing, where consumers and investors suddenly start spending more because they feel richer, is a lot weaker than previously believed. If the wealth effect were strong low wage growth  would worry investors about weak demand. (And Scott Sumner correctly argues that the small increases are a supply side phenomenon).

And in a normal market, that’s exactly what would have happened. However, the Evans rule is framed so oddly that stock markets can, for a very long time, benefit directly from a stagnating economy. Investors are now reassured that QE will continue. They are dreading a real recovery. Even if policy was contingent on monthly job creation, today’s report would have assured investors, but at least that response would be measured by the economy itself, than an artificial statistic.

Even then, the perversity of QE is clear. Obviously, considering QE’s transmission mechanism, asset prices have to increase. However, we should at least believe that a lot more of the stock market boom in the past few months is QE and AS rather than improvements in demand. Otherwise, today’s jobs report should have been met with a “meh” response from the Dow.

The thought experiment is this. Let’s say May was a fantastic month, and the BLS prints a fabulous report. Would the stock market go up? To the extent it falls, or doesn’t rise as we would hope to aggregate expected growth (which is high, because the market knows the economy has done well) – QE is a distortionary force. It’s not a bubble, but it clearly confuses markets.

A well-designed QE policy would offset the market effect of information from the jobs report vis-a-vis its “natural” trend. What does this mean? If the job market was booming investors would face two countervailing forces 1) an expected tapering of QE and 2) increasing consumer confidence and demand (which moves in line with the market). If the jobs report sucked, investors would be confident in continued QE, but worry about falling demand.

This is a sterile design that doesn’t approximate the real world, but can inform what a correct QE policy would look like. For one, the value of asset purchases would be proportional to (or correlated with) job creation.

I suspect this is a rather confused post, but I’m trying to collect my thoughts. Hopefully I can produce a more detailed and cogent post later.


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