The central bank made bubble

In response to economic downturns, central banks have deployed large-scale asset purchases—known as quantitative easing (QE)—to stabilize financial conditions. However, these interventions have had unintended consequences.

QE is effective in lowering yields but exacerbates financial distortions by worsening the safe asset shortage, pushing capital into equities, and inflating prices beyond fundamentals.

The Paradox of Monetary Intervention

As the Chinese say, we truly live in strange times. For the first time in modern financial history, central banks are deliberately inflating stock prices as a side effect—or even a tacit goal—of their monetary policy. Despite being fully aware of the consequences, they continue down this path, making today’s economic environment not only unusual, but dangerously unbalanced.

What is an asset price bubble?

An asset price bubble occurs when market prices rise significantly above an asset's fundamental value—the present value of expected future cash flows or utility—due to speculative demand, irrational exuberance, or market inefficiencies. Bubbles are characterized by:

1. Exponential price increases detached from fundamentals

2. Over-optimistic expectations of future price appreciation

3. Herding behavior among investors

4. Eventual collapse (crash) when reality corrects expectations

Quantitative Easing and the Disappearance of Safe Assets

Even before the COVID-19 shock, central banks had reached the limits of conventional policy. With short-term interest rates pinned at the zero lower bound, the only remaining tool in their arsenal was quantitative easing (QE)—the large-scale purchase of financial assets, primarily government bonds and investment-grade securities. Once the pandemic hit, QE was deployed rapidly and on an unprecedented scale.

By 2021, the U.S. Federal Reserve held over $8 trillion in assets, with U.S. Treasuries making up $5.8 trillion—approximately 25% of the entire outstanding Treasury market (Federal Reserve, 2021). This level of market absorption has measurable effects. According to Caballero, Farhi, and Gourinchas (2017), the global supply of AAA-rated government debt as a share of GDP fell from 44% in 2007 to below 20% by 2011, due in part to financial crises and exacerbated by central bank purchases.

This artificial tightening in safe asset supply imposes upward pressure on their prices and depresses yields, leading to distortion across the yield curve. The average 10-year Treasury yield fell from 4.6% in 2007 to 1.5% in 2021, with QE programs accounting for a 60–80 basis point reduction in yields, depending on the program and maturity (Gagnon et al., 2011).

The Portfolio Rebalancing Trap

With deposit rates near zero and bond yields suppressed, capital is reallocated to riskier markets, most notably equities. This “portfolio rebalancing” effect is a core QE transmission channel (Gagnon et al., 2011). But its implications are far-reaching: equities become the primary outlet for capital seeking yield.

According to the IMF (2020), countries with larger QE programs experienced a 15–25% faster rise in stock market capitalization post-COVID compared to countries without such interventions. In the U.S., the S&P 500 increased by 70% between April 2020 and April 2021, during the height of the Fed’s QE, despite GDP and employment remaining well below pre-pandemic levels.

Koijen and Yogo (2020) show that shifts in institutional investor demand caused by QE can explain over 50% of cross-sectional variation in equity prices, especially in low-interest environments.

Risk-Taking Without Real Investment

Central banks purchasing corporate bonds push yields down and incentivize riskier corporate borrowing. However, these funds are often not used for capital investment. According to Acharya and Plantin (2023), during the COVID QE period, only 15% of bond proceeds were allocated to physical investment or R&D, while over 40% was used for stock buybacks and dividend payouts.

Meanwhile, non-financial firms increased debt issuance by nearly $1.3 trillion in 2020, yet U.S. gross private domestic investment declined by 6.3% (BEA, 2021). The disconnect between cheap financing and real economic activity underscores how QE encourages financial engineering over productive expansion.

Misremembering 2010: A Faulty Analogy

Why do central banks persist? Likely due to the apparent success of QE in the post-2008 recovery. However, that era was marked by improving fundamentals. In 2010, GDP growth had returned, bank balance sheets were being repaired, and housing markets were stabilizing. In contrast, the COVID QE occurred amid falling output and high uncertainty.

In 2010, QE1 was associated with a 15% rise in equity markets over 12 months and a parallel rise in business investment. But in 2020–2021, the same asset price growth occurred despite a 3.4% contraction in U.S. GDP and the loss of over 20 million jobs, suggesting a decoupling of asset prices from macro fundamentals.

Bubbles Backed by Central Banks

Stock valuations in recent years have reached levels rarely seen in history. The CAPE ratio (cyclically adjusted price-to-earnings ratio) for U.S. equities hit 38 in late 2021, second only to the dot-com bubble (Shiller, 2021). Asset prices today are not driven by earnings expectations or productivity, but by liquidity and the belief that central banks will not let markets fall.

Jorda, Schularick, and Taylor (2015) demonstrate that credit-fueled asset price booms are the strongest predictors of future financial crises. Brunnermeier and Sannikov (2014) argue that prolonged monetary easing can create “endogenous risk,” where the very success of policy breeds fragility by encouraging leverage and moral hazard.

Conclusion: From Stabilization to Fragility

In conclusion, central bank asset purchases—though well-intentioned—have had counterproductive effects in the current economic context. By worsening the safe asset shortage (Caballero et al., 2017), they push investors into riskier assets (Koijen & Yogo, 2020), reduce productive investment (Acharya & Plantin, 2023), and contribute to financial market bubbles (Brunnermeier & Sannikov, 2014; Jorda et al., 2015).

Statistical evidence confirms that QE depresses safe yields, alters investor behavior, and inflates asset prices beyond economic fundamentals. In doing so, it may sow the seeds of future instability—replacing short-term liquidity relief with long-term systemic fragility.

References

Acharya, V. V., & Plantin, G. (2023). Monetary Easing and Financial Instability. Review of Financial Studies, 36(1), 1–41. https://doi.org/10.1093/rfs/hhac026

Brunnermeier, M. K., & Sannikov, Y. (2014). A Macroeconomic Model with a Financial Sector. American Economic Review, 104(2), 379–421.

Bureau of Economic Analysis (BEA). (2021). Gross Domestic Product by Expenditure.

Caballero, R. J., Farhi, E., & Gourinchas, P.-O. (2017). The Safe Assets Shortage Conundrum. Journal of Economic Perspectives, 31(3), 29–46. https://doi.org/10.1257/jep.31.3.29

Federal Reserve. (2021). H.4.1 Factors Affecting Reserve Balances.

Gagnon, J., Raskin, M., Remache, J., & Sack, B. (2011). The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases. International Journal of Central Banking, 7(1), 3–43.

International Monetary Fund (IMF). (2020). Global Financial Stability Report: Markets in the Time of COVID-19.

Jorda, Ò., Schularick, M., & Taylor, A. M. (2015). Betting the House. Journal of International Economics, 96(S1), S2–S18. https://doi.org/10.1016/j.jinteco.2014.12.011

Koijen, R. S. J., & Yogo, M. (2020). A Demand System Approach to Asset Pricing. Journal of Political Economy, 128(4), 1374–1437. https://doi.org/10.1086/705825

Shiller, R. J. (2021). Online Data: CAPE Ratio. Yale University. http://www.econ.yale.edu/~shiller/data.htm