The Fed’s Best Rationale for QE3
The basic case for the Federal Reserve’s third round of quantitative easing is simple and airtight. The fine print is more complicated, and the Fed’s inability to explain itself makes this worse -- but don’t let the details obscure the main point. QE3 was the right move.
The U.S. economy needs QE3 because it is suffering from a deficiency of demand and because the Fed’s policy interest rate is already at zero. It also is the right decision because the paralysis in Washington rules out the first choice under such conditions: further fiscal stimulus.
Nobody, as far as I know, is denying that with so many workers and other resources idle, the economy needs more demand. To oppose quantitative easing, you have to argue that it won’t have the required demand-inducing effect.
That argument takes three forms: Two are intelligible; the third isn’t.
The first intelligible argument is that QE itself is too puny. Some think that when the Fed buys lots of assets -- including, in the case of QE3, mortgage-backed securities -- investors will adjust their portfolios in ways that leave overall demand unchanged. To provide effective stimulus, you need something stronger, such as a promise to allow higher inflation even after the economy has returned to full employment.
There’s something to this idea. QE has been tried twice before, and we may be seeing diminishing returns. The evidence suggests it helped, but probably less potently (allowing for the size of the program) the second time. The new phase of QE is only moderately sized, at $40 billion a month, but open-ended. The Fed says, albeit vaguely, that the purchases will continue until the economy strengthens. This open-endedness increases the potency, and QE3 is likely to spur demand as intended.
The second intelligible objection is that QE3 will have unintended consequences. For instance, as Fed Chairman Ben S. Bernanke mentioned at last month’s central bankers’ meeting in Jackson Hole, Wyoming, the sheer scale of these cumulative operations might hobble ordinary market forces.
“Conceivably,” he said, “if the Federal Reserve became too dominant a buyer in certain segments of these markets, trading among private agents could dry up, degrading liquidity and price discovery.” That could block the channels through which ordinary monetary policy works. But Bernanke said the Fed was watching this closely and saw “few if any problems” so far.
QE3 is new terrain, it’s true. It would be foolish to rule out unintended consequences. But the technical issues that analysts and economists have raised look manageable. The costs of allowing deficient demand to persist are both huge and certain. They easily outweigh these risks.
The unintelligible objection to QE3 is, as you might expect, the most popular in political circles. This is the idea that the Fed’s new measures will directly result in higher inflation without doing anything to increase demand and output. Sure, once the economy is back at full employment and resources begin to be stretched, monetary stimulus of any kind would be inflationary. Sadly, the economy is nowhere near that point.
With so much of productive capacity idle, higher demand will boost output. Any increase in inflation will be small and, as long as the stimulus stops promptly, consistent with the Fed’s long-term inflation goal.
A skeptic might argue that inflation expectations ticked up when the Fed announced QE3, which they did. That’s all right, because they needed to. According to the Cleveland Fed’s measure, 10-year expected inflation was well under the Fed’s target of 2 percent before Bernanke made his announcement last week. (Other measures of expected inflation, such as the difference in yields between ordinary and inflation-protected Treasury securities, give a slightly higher number, but they don’t measure expectations as accurately.)
Certainly the Fed will be watching to ensure that inflation expectations don’t get out of control. There’s no question that too much demand will eventually be inflationary. At the moment, though, the economy is short of demand. It’s that simple.
A fairer criticism of the Fed is that it’s failing to explain itself. If you doubt this, just sample some of the commentary on the Fed’s new actions. There are almost as many theories about what it’s “really” up to as there are Fed- watchers.
We are left with this: QE3 is consistent with what the Fed has done before, or it’s a historic innovation signaling a whole new approach, or it’s something subtle in between. The Fed wants higher inflation, or it is more willing to take a chance on higher inflation (even though it would prefer to avoid it), or it remains as vigilant on inflation as before. The Fed has promised to keep interest rates at zero for three more years regardless of what happens, or it has said only that it expects this will be necessary (and would be delighted to be proved wrong).
All through his time in the job, Bernanke has stressed the need for clarity and openness in the Fed’s deliberations. Clarity this is not.
I don’t blame him. In my book, he’s a hero. But the poor guy is in an impossible spot. He isn’t an autocrat like his predecessor, Alan Greenspan, so he has to finesse disagreements on the Federal Open Market Committee about whether and how to provide new stimulus. He also has to deflect the mostly dumb criticism he’s getting from Republicans in Congress.
Nonetheless, it matters that the Fed’s intentions aren’t clear, for all the reasons Bernanke has emphasized in the past. It’s easier for the central bank to push the economy where it wants it to go -- bolstering growth when unemployment is high while keeping inflation controlled -- if its intentions are understood and its commitments are believed.
It’s easier said than done. The debate about the right target framework for Fed policy -- forward-looking or “history dependent”; inflation targeting or nominal income targeting; paths, growth rates or hybrids; rules, discretion, or something in between -- is a long way from settled, and probably never will be. And remember that whichever school of thought the Fed decided to align with, there would be different ways of applying it.
The confusion can’t be entirely dispelled. The Fed could and should do more to clarify its approach, but the controversies will never end.
Meanwhile, what matters is to focus on what shouldn’t be controversial at all. Is demand in the economy too weak to keep its resources adequately employed? Yes. Are inflationary pressures building? No. Can QE3 deliver some stimulus? Yes. That’s as much as you need to know to congratulate the Fed.
(Clive Crook is a Bloomberg View columnist. The opinions expressed are his own.)
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