October 20, 2010
Arguments against QE2
Having earlier reviewed some of the reasons in favor of additional quantitative easing (QE2), I'd like to acknowledge some of the dissenting views.
it is no exaggeration to say that a protracted and rigourously implemented round of QE2 in the United States could put so much pressure on the euro that the common currency would be put in danger of shattering under the pressure. Japan is already heading back into recession, as the yen is pushed to ever higher levels, and Germany, where the economy has been slowing since its June high, could easily follow Japan into recession as the fourth quarter advances.
Perhaps there's some basic issue I'm overlooking, but here's how I see it. If other countries want to prevent their exchange rates from appreciating, they should respond with easing of their own, which from my perspective would be a win-win outcome for everybody. If other countries feel that easing is contraindicated for their domestic situation, then isn't that part of the case why the dollar needs to depreciate relative to their currencies, given the current economic conditions in the U.S.?
(2) Stanford Professor Myron Scholes raises a separate issue:
If the Fed takes on more risk, society still has the risk. The risk doesn't go away, any more than the risk of holding subprime mortgages went away before the crisis. We cannot structure the risk such that it disappears. Society still has the risk, and will want to hold safe assets if the Fed affects the risk premium.
I think that's a very important observation. Here's how Cynthia Wu and I have been thinking about this issue within the context of our recent paper claiming that the Fed could flatten the slope of the yield curve by buying more long-term bonds:
Certainly from the perspective of an individual investor, a 10-year Treasury bond has different risk characteristics from a 6-month T-bill, and these differences get priced by the market. If an individual investor changes her relative holdings of these assets, she perceives herself to have a different risk exposure, and perceives the U.S. Treasury to be the counterparty.... If the government changes the maturity structure of its outstanding debt, it is in fact committing to a different state-contingent path for spending, taxes, or inflation.
The time path of spending, taxes, and inflation are part of society's risk structure that Scholes is discussing, and is something that we assume would have to be altered as a result of these kinds of policy choices. Our interpretation is that the average positive upward slope to the term structure comes from the historical desire of the government to pass along interest-rate risk to its creditors.
But why the Fed? The Treasury is a huge player in the bond market. They are still selling long term bonds. Why? What if the Treasury decided to finance the deficit with 1 and 3 month T-bills alone?
Again this is an excellent question, and one with which I also have struggled. In terms of my theoretical understanding of the mechanism by which large-scale asset purchases might be effective, the operation is identical whether implemented by the Treasury or the Fed. One reason one might give for having the Fed conduct the operations is the possible additional benefits of using it as a signal and framework for the conduct of future monetary policy. A second is that the primary goal of the proposal is to prevent what I regard as a harmfully low level of inflation, and targeting inflation is traditionally the responsibility of the Federal Reserve rather than the Treasury.
(4) Federal Reserve Bank of Kansas City President Thomas Hoenig has expressed the following concerns:
without clear terms and goals, quantitative easing becomes an open-ended commitment that leads to maintaining the funds rate too low and the Federal Reserve's balance sheet too large.... rather than inflation rising to 2 or 3 percent, and demand rising in a systematic fashion, we have no idea at what level inflation might settle. It could remain where it is or inflation expectations could become unanchored and perhaps increase to 4 or 5 percent.
Again I agree that these are critical issues. At a minimum, we need to acknowledge up front the limited potential of QE2 and be prepared to admit when it has accomplished all it can. Options for limiting the commitment include targeting the 2- or 3-year Treasury yield or announcing an exit strategy based on a particular level for the core PCE, as I discussed here. I've also urged the Fed to keep a close eye on commodity prices through this process.
(5) A final concern is that QE2 will be ineffective in restoring full employment. Variations on this perfectly accurate statement have been made by a great number of people; for a recent collection see Yves Smith. But the issue is not, and in my mind has never been, whether monetary policy can "solve our problems". Instead the question is whether a sufficiently low or negative rate of inflation would make our problems worse. If it would make our problems worse, then the goal of monetary policy is to avoid doing that. Here's another reminder from the October 14 FedViews of what's at stake:
Posted by James Hamilton at October 20, 2010 06:50 AMdigg this | reddit
Very good post. I would suggest that many commentators, including economists, are missing the point of QE2: to ward off disinflation/ deflation and all of the evils associated with it. It has little to do with currency wars or using interest rates to stimulate the economy.
Regarding #1: while that is certainly a concern, a break-up of the Euro would primarily come from disparate fiscal structures and/or overly conservative monetary policy. Japan already has overly conservative monetary policy, which appears to be a function of their high levels of debt (inflation and rising interest rates would bankrupt the government).
#2: I read that too, and was a little mystified as I thought the point was largely irrelevant.
#3: A treasury intervention would be, by definition, a sterilized intervention. That's another definition of fiscal policy, which is a different debate. QE2 (unlike QE1, which was a reverse sterilization) would be largely unsterilized.
#4: A very important concern, but doing nothing risks deflation, which would be worse than 4 or 5% inflation. Level price targeting could go a long way to solving that problem. A few weeks ago, the BAA and AAA bond markets appeared to be pricing in 1% deflation (with a "d") over 10 years. The problem is that official measures of inflation are overstating current inflation (by using bad proxy for housing prices)
#5: QE2 won't restore full employment, though level price targeting would probably undo at least some of the damage that the deflation of 4Q 2008 did to the labor markets.
Posted by: Dan Carroll at October 20, 2010 08:19 AM
You left of Stiglitz's comments in yesterday's FT.
"Given the complexity of the economic system, the difficulties in predicting how expectations will be altered, and the pervasive irrationalities in the market, there is no way the impact of any economic policy could be ascertained with certainty. There may be some circumstances in which the effect of monetary policy can be accurately gauged. But recessions of this depth come only once every 75 years. What is true in normal times may be of little relevance now, especially as central banks engage in unusual measures such as QE."
It's somehow comforting to hear an economist admit that guessing at outcomes sometimes isn't enough.
Posted by: Bob_in_MA at October 20, 2010 08:31 AM
If the Fed purchased $1 trillion treasuries and the Treasury issued $ trillion new treasuries to cover the deficit, is that not equivalent to the Treasury spending by the Fed crediting reserve balances?
What is QE trying to accomplish? Is it to lower lending rates so the public will go into debt to fuel expansion? But don't we have too much private debt? Makes no sense to me.
Has anyone considered QE may have deflationary consequences. If it brings down the interest rate the govt pays, will this not cause a negative fiscal injection as interest payments are a form of govt spending. And if business have lower interest expense they can be forced to pass this savings (because of competition) into lower prices. Isn't that the definition of deflation?
The answer to the current economic mess is a payroll tax holiday. This will restore aggregate demand. And the govt does not have to worry about making SS payments. As stated above, the govt spends by the Fed crediting reserve balances. Taxes are needed to control aggregate demand (and inflation). So if and when inflation becomes a problem the tax can be reinstated.
Posted by: markg at October 20, 2010 08:57 AM
Would the USD depreciation be US export beneficial
Threats to the World Economy Remain: Prospects for Growth And Rebalancing
By Menzie D. Chinn
When reading M Chinn [Chart 4] there has been the beginning of a correlation on a two years lag between the dollar value and the trade balance.The ratio of US net export was improving.
More convincing in 2005 than in 2010 and less convincing on a 2 years (2012) further extrapolation,as sustained by the assumption everything remaining equal.
On a balance of payment standpoint, 2005 is as well the pick of the US direct investment abroad.
Series: BOPOPDA, U.S. Private Direct Investment Abroad
Is it the trade balance or the current account that matters?
Evidence on Financial globalization and crisis Global imbalances M Chinn
Through separate study M Chinn shows a flattening of the current account balance with larger spread out (P5) How much export is needed through EXR in order to decrease the CA distribution or how much less US capital outflows?
As for the sovereign bonds markets and the economies, the greatest danger is a market sell off through the different trading floors of the derivative markets.
One may assume the federal reserve Bank to have better control of the prices and interest rates by holding the TB and the supervision of the Banks level of reserves all to gather.
As regards the inflationary fears and inflation forecasts.The hereunder paper is humbly introducing the coin flipping as an argument of detraction as regards the reliability of methods and models when ti comes to inflation forecast.The margin of errors are wide, 5 to 7 years lifespan.
When can we forecast inflation?
J Fisher,Chin Te liu,Ruilin Zhou
PS All in,your posts are requiring too much work.
Posted by: ppcm at October 20, 2010 09:00 AM
I think QE can cause disinflation/deflation. Lower income expectations and higher consumable prices increase the need for savings. At the same time it makes saving, paying down debt, and investing more difficult for the broader population.
Like when energy prices go up, other consumption goes down by even more than the price increase. When commodity prices go up, other consumption will make drop by even more than the additional cost. When commodity prices are the biggest movers, it will make people very nervous about spending.
As living expenses increase, people will be less willing and able to spend on bigger ticket items, rent, mortgages, and investment.
Unless constraints in supply of commodities are reduced, we'll just see rent seeking behavior rather than investment in production. This is the dynamic I think we're in.
Posted by: aaron at October 20, 2010 09:05 AM
If CPI excludes Food and Energy then is the discussion primarily about the "Service" Economy?
Can someone please explain what it means to have high food and energy inflation and low "services" inflation (or a deflation threat).
To a layperson it seems we are having both high inflation (higher energy & food prices) and low inflation (threat of deflation) in services?
My understanding is that "services" pricing is inherently much more flexible - as it has lower fixed costs than food & energy.
So why is "deflation" in services such a bad thing? Is it that, in a service economy, it translates to massive unemployment?
How does one reconcile and make sense of these conflicting divergent aspects of inflation?
Posted by: Jeremy at October 20, 2010 09:05 AM
I guess I should point out that the biggest argument for QE is the unfounded assumption that it "works" (insert any definition for "works" here)and Japan is the showcase for it's successful implementation.
Might as well type the disclaimers that proponents will no doubt feel obligated to post.
1) Japan/we/ROW waited too long to do it.
2) Japan/we/ROW didn't do it big enough.
3) Japan/we/ROW would be worse off without it.
4) Japan/we/ROW is absolutely sure it doesn't/didn't/never will do anything bad.
There. All done.
Posted by: Cedric Regula at October 20, 2010 09:13 AM
A simpler approach would be to increase the minimum wage, by a very substantial amount. That would certainly put cash in the pockets of people who would spend it, increase aggregate demand, and jump-start the economy in a big way.
We might consider offsetting the cost to small businesses by a tax credit, to avoid job losses.
We might also consider directly increasing prices by means of excise taxes, to offset the cost of the tax credit.
Those three things together would do wonders, in my view, in terms of inflating the sails of our economy. All of this is, of course, politically impossible, however effective it might prove to be.
Posted by: MRJ at October 20, 2010 09:17 AM
I want to second Bob in MA: What about the "unknown unknowns"?
Approaching a poorly-understood complex system with an untried approach is something that would never be attempted in another situation (say fixing a car engine) unless the certain alternative was disaster? Are we sure that the alternative is a disaster?
Posted by: jult52 at October 20, 2010 09:23 AM
Which of these scenarios has greater probability of preventing deflation. For easy math, assume QE2 = $1.5T spread over 10 months.
1. QE2, FED purchases creating an increase in excess reserves and a decrease in medium/long term treasury rates.
2. FED creates $150B per month and pays it out directly to our ~150 million labor force at $1000 per month. (Or a gradually increasing payment then gradual decline over a longer time frame.)
It seems scenario 2 would has a better chance of temporarily preventing deflation than scenario 1.
Why not let the FED create money and dole it out directly to HH's? A virtual helicopter drop. Why go through the indirect channel of the excess reserve balances at the 20 (or whatever it is now) primary brokers/banks?
Posted by: tj at October 20, 2010 09:34 AM
2) The universe of investors in these securities and "society" are not exactly the same.
3) Financing solely through short term debt at a time of record low interest rates seems a bad idea. Going long to take advantage of the low rates seems a better idea.
4) The goal seems to be 2% inflation and something closer to full employment. Is there such a thing as too much employment in the absence of high inflation? Where's the lack of clarity?
Posted by: foosion at October 20, 2010 10:12 AM
Very nice posts about QE, JDH. Thanks!
About that SF Fed chart: somebody needs to tell them that JPY appreciated from a low of 159 yen for a dollar in Aril '90 to the high of 84 yen for a dollar in April '95 (monthly averages). In comparison, the broad trade weighted dollar has DEPRECIATED from about 125 at the beginning of 2003 to about 1.02 now. Talking about apple to orange comparisons!
Posted by: PS at October 20, 2010 10:24 AM
I posed possibility 1) some time ago on these boards. I still think it is a major problem, especially since it seems it is not just the dollar that QE will cause to depreciate against the euro, but the pegged Asian currencies as well (the 'Chimerican' currency).
JDH: "If other countries want to prevent their exchange rates from appreciating, they should respond with easing of their own, which from my perspective would be a win-win outcome for everybody. If other countries feel that easing is contraindicated for their domestic situation, then isn't that part of the case why the dollar needs to depreciate relative to their currencies, given the current economic conditions in the U.S.?"
The problem is, the euro area is not one country in one situation. Some fall under your first case and others fall under your second case. But they have only one monetary authority and one monetary policy. One can argue that they hav no business with a single currency, but that won't make the effects of a breakup any easier for markets to stomach.
Hoenig: "It could remain where it is or inflation expectations could become unanchored and perhaps increase to 4 or 5 percent."
And exactly. When you are creating inflation out of ephemeral expectations, with no traction from constraints of employment or capacity (and in fact against all the natural market forces from excess capacity and high unemployment), who's to say that you will get exactly what you want? In such circumstances, I would be surprised to see inflationary expectations "anchored" (anchored to what, exactly? to Ben's waffling comments?) and not a bit surprised to see market participants become unhinged.
Posted by: don at October 20, 2010 11:31 AM
EGADS! QE2 will be implemented just like QE1.... The FED purchases impaired securities from primary dealers at inflated prices. The FED bribes the same banks to hold some of the money as "excess reserves" by offering interest, the rest of the money is used to buy high interest foreign sovereign debt, inflate equities as well as commodity prices.
As a corollary, QE allows the FED to keep interest rates very low by buying Treasury securities. This prevents interest payments from overwhelming the Federal Budget, as well as highly leveraged businesses and households.
Quantitative Easing is all about keeping the existing oligarchy in their deck chairs. There are huge losses that have to be realized from the securitization epidemic. QE is all about passing those losses on to the hoi polloi. Nowhere in the arguments against QE2 do I see the words Justice or Equity. Exactly why should the rest of society subsidize the elites out of their fraudulent investments?
Posted by: MarkS at October 20, 2010 11:36 AM
Asking why the Fed should be involved in changing the shape of the curve, rather than the Treasury, reveals an insufficiently parochial mind. The Treasury's role is to handle finance for the government, and in service of this role, it works to match the maturities of assets and liabilities. It asks major Treasury security purchasers what mix of maturities they would like. The Fed, on the other hand, has the job of managing employment and inflation. It's true that a more efficient arrangement may be conceivable, but a more efficient arrangement might not satisfy the mandates of the Treasury and Fed.
Posted by: kharris at October 20, 2010 01:03 PM
Bric nations grow weary of G20 rhetoric
By Alan Beattie in Washington (FT)
Published: October 20 2010 19:34 | Last updated: October 20 2010 19:34
If there is one consistent cliché in the cloud of platitudes that billows forth about the tremendous importance of the G20, it is that the grouping gives big emerging markets their long-awaited seat at the table.
So it is more than a little disturbing that India, one of the most important of such governments, thinks said table conversation is marked more by sterile dissent than constructive debate. It is even more disturbing that Brazil is prepared to leave its chair empty.
Senior officials from Manmohan Singh’s government told the Financial Times this week that the G20 was in “serious difficulties”, with no agreement on diagnosis. Guido Mantega, Brazil’s finance minister, the man who had the courage to call a currency war a currency war, decided not to attend this week’s meeting of ministers and central bank governors in South Korea at all. And on Wednesday Ali Babacan, Turkey’s deputy prime minister, weighed in with his own concerns that the positions taken by the grouping were sinking to a lowest common denominator.
Brasília insists that Mr Mantega will accompany his boss, Luiz Inácio Lula da Silva, the president, to the heads of government summit in mid-November. But showing such little faith in the planning stage does not inspire confidence in the main event.
If the G20 really is losing credibility with Brazil and India, it is in serious trouble. As a US Treasury official put it: “Brazilian and Indian officials are among those . . . that have the most to gain from the G20, and have been its strongest supporters.”
On Monday the tax on foreign purchases of G-bonds was raised from 4% to 6% in Brazil. This in an effort to slow the tide of mostly dollar carry-trade flows that are driving up the value of the real. India, South Korea, and Indonesia have spoken of similar plans to enact capital controls. Thailand also has 15% tax in place.
It seems the emerging nations are saying 'no' to QE with their actions.
It is surprising how much is said about QE and low interest rates in the MSM etc., without any mention of how this is causing economic havoc across the world. The Brazilian real has gained nearly 5 percent to the US dollar since September, with a total increase on the real coming to about 30 percent in the last 18 months. Other currencies have had a similar reaction to the flood of liquidity coursing through the global economy due to interest rates in the developed nations being so low for so long. But... if the mainstream press were to be relied upon it might seem that only China manipulates its currency in a self-serving way?
Posted by: rayllove at October 20, 2010 02:17 PM
QE is worthless. The market hasn't accepted this fact yet and will struggle to do so, but when they do, it can't come a moment to soon. The FED's current manners of monetary policy will either have to change or capitulate and accept paralyzation. The latter may be more acceptable to the many.
Everything 'printed' dies. It doesn't exist and becomes irrelevant. Hence, nothing was printed. A tool they used to put stability into the financial system late in 2008 without doing anything, but even that ends at some point because the wounds are not being treated. Just the pain.
It will return. The need for economic overhaul of a global system that has failed is the only truism. But letting go of the past can be hard. Not only for bankers and capitalists. But for everyday Joe's crying over the lack of a single payer or bailouts for a system they helped vote into power over the last 20 years. The economic boom is over and the crash has occurred. Debt deflation is here and the system is defunct. Cutting spending and what little tax revenue we have from what job base we have left, won't bring back the boom. Creating short term "stimulus programs" with no cohorent message to change the structure of the economy won't bring back the boom either.
One thing FDR had was being a blue blood himself and a ex-President who reacted far to late in the depression which ironically helped spur the 1933 growth surge and allowed the blud blood to push around his flock and call it a success.
Some politicians need to sacrafice themselves and admit what they believe is wrong. From all across the beltway we need self-serving politico's offering themselves up for cruxifiction and redemption.
Posted by: The Rage at October 20, 2010 03:21 PM
You think bond sales and quantitative easing are the same? Don't give up your day job! What's that, your day job is economics? *Now* I'm worried about the future of the dollar.
No wait, I was already worried:
See also the first comment here, subitem #3.
Posted by: Carl Lumma at October 20, 2010 03:23 PM
Here's a chart of Templeton Global Bond Fund. They are all sovereign bonds, mostly in Asia ex Japan, Brazil and Scandi countries. Little in the eurozone. Keep in mind they pay out the bond interest earned. They also have a Euro short equal to 20% of the portfolio and a yen short at 10%. They have been nailed on these short positions since mid year, of course, but even with that plus paying out bond interest, they still are at almost at $14 a share. This is an open ended bond mutual fund that started at $10 a share.
Posted by: Cedric Regula at October 20, 2010 03:34 PM
Carl Lumma: The Treasury could retire a 10-year T-bond by issuing a liability in the form of a 4-week T-bill paying 14 basis points. The Fed could retire a 10-year T-bond by issuing a liability in the form of reserves paying 25 basis points.
What's your day job?
Posted by: JDH at October 20, 2010 03:46 PM
The pending downswing in the economy will last maybe 3 months. If the FED uses QE, instead of lowering the remuneration rate, it will be forced to raise the renumeration rate, almost immediately thereafter, to halt a quick rebound in the price-level.
Then the FED will be blocked at the exit, & higher levels of un-used & un-needed excess reserves will once more, restrict bank lending & investment (i.e., the result will be higher Federal bank subsidies - with higher taxpayer costs).
Posted by: flow5 at October 20, 2010 05:31 PM
Calculated Risk eavesdropped on some top secret webcasts of bank CEOs discussing commercial and investment loan demand. These are very similar conversations the Fed has with these same people when harvesting info for the popular Beige Book publication.
How the Fed connects the dots from here to QE2 is quite a mystery. No word that money supply or cost of money is a concern.
Posted by: Cedric Regula at October 20, 2010 06:03 PM
In your NYT post, you said:
"all USD-denominated, non-inflation-indexed obligations (savings) in the universe drop in value."
On what planet are you living? Where did you see US bonds dropping in value since the beginning of the financial crisis?
Also, you might see a huge difference between T-Bills and excess reserves in the lalaland you live in, but I regret to tell you that guys actually holding the stuff -namely financial institutions- do not see any difference. They consider these assets almost perfect substitute.
Posted by: Qc at October 20, 2010 07:30 PM
I appreciate your doing this topic. You neglected an important reason against QE2:
It is impossible to inject large quantities of freshly minted money without distorting relative prices. Just as a helicopter drop would produce unrealist prices for consumer goods, the purchase of bonds distorts the prices of investment assets. The plans of entrepreneurs are mislead by the artificial cheapness of credit.
For instance, the demand for autos in the US would be significantly less with market interest rates than they are with the present artificially low rates. Automakers are being mislead to maintain a capacity to produce that will be unsustainable in the long run.
Am I wrong to think that economists have an interest in the long run?
Said another way, QE2 will further disrupt the microeconomic co-ordination process the accurate relative prices allows.
Posted by: Bryce at October 20, 2010 07:30 PM
With respect to one, can't it simply be that the US authorities might be seen by other countries as being reckless?
You could make the same argument with forex intervention, but I'm not sure it gets us anywhere.
Posted by: Matthew at October 21, 2010 12:47 AM
@JDH Sorry, changing the yield curve is not the same as creating money. While reserves are technically Fed liabilities, the bonds backing them are destroyed in practice. Last I checked, the Treasury has never defaulted on bonds sold to anyone else, regardless of maturity.
Incidentally, this is one reason the MBS-heavy QE1 was not terribly effective in boosting AD -- the Fed is still collecting the payments. Only much later did they announce they would (for now) return those payments to the economy, and *this* announcement did move the needle.
@Qc For brevity's sake my NYT comment neglects to mention that this only occurs if there's actually enough QE to exceed the demand for money and inflate the currency, AND this fact is communicated to the public. QE1 failed on both counts. The inflation rate has been going *down* throughout the crisis.
Yes, the zero bound constrains conventional monetary policy but not - repeat not - QE. As long as the public believes the inflation rate is increasing, the composition of bank balance sheets is irrelevant. An increasing inflation rate lowers all interest rates in the economy, including those on consumer debt. It indiscriminately depreciates bank reserves and investments. It also depreciates the dollar relative to other currencies, which is normally something of a constraint but at the moment happens to be something we sorely need to rebalance trade with Asia.
Posted by: Carl Lumma at October 21, 2010 12:48 AM
A few quick comments on the ZLB paper...
With over a trillion dollars in excess reserves, the United States presently appears to be well past the satiation point for Federal Reserve deposits.
That banks are holding these reserves indicates a demand for them.
The failure of the Fed to follow the theoretical policy prescription of trying to increase inflationary expectations in response to the crisis is not so much an indictment of the Fed as it is a clear demonstration that these expectations are far more difficult to control in practice than simple theoretical treatments might sometimes suppose.
How is the failure of the Fed to try something evidence it wouldn't have worked? In fact, they finally did just try it, and it did just work. In the 54 days since their recommitment to 2% inflation, the renminbi forgot its 2-year fascination with the dollar and the S&P500 shot up 12%.
A related question is why the government would choose to use taxes rather than money creation as the means to pay for any of its current or projected future expenditures.
Because history has shown that giving governments the power to create money usually results in hyperinflation. It's why we have the Fed and it's why the Fed normally can't buy bonds directly from the Treasury. But the Fed can create arbitrary demand for treasuries, and that's what so much of this zero bound stuff ignores. During QE, every time a bank flips a bond to sit on the reserves, newly-created money goes to the government to be spent.
Posted by: Carl Lumma at October 21, 2010 01:53 AM
"Perhaps there's some basic issue I'm overlooking, but here's how I see it. If other countries want to prevent their exchange rates from appreciating, they should respond with easing of their own, which from my perspective would be a win-win outcome for everybody."
Oh dear, professor, foreign exchange rate is all implicitly pegged despite "floating" (otherwise how would do foreign exchange at all?). As the world trading currency, everything is both implicitly and explicitly pegged to usd. If everyone resort to QE or any variant, there will be no net gain for any participants. Certainly not a win-win, and definitely a lose-lose situation (expansion of money base without the benefits).
And regards to the yield curve, central banks of their perspective country can always manage the curve at will (after all, they primarily expand money base by creating new money and buying bonds, it's what they are set up to do, functionally). The failure to pass on the lowered cost of capital despite QE or other variant remains to be problem, not the amount of QE. It's like having a fat water pipe, a lot of pressure and yet the pipe is blocked. Arguing for more QE is on shaky grounds.
Posted by: FX at October 21, 2010 02:05 AM
Bryce You've mentioned this before and I don't see where you're coming from. One of the main reasons we're even talking about QE2 is the risk of deflation, and deflation is not (contrary to what many believe) a condition of price stability. What you seem to be missing here is any recognition that deflation is itself a disrupter of macroeconomic activity. You might be interested in a link that Mark Thoma has over on his site that will take you to a short video lecture by George Evans. Evans has a nice explanation using phase diagrams showing how deflation is destabilizing in the sense of being a "bad" saddle point. The video assumes some knowledge of simple ordinary differential equations, but other than that it's pretty straightforward. Evans' argument is that deflation can become a divergent phenomenon.
You need to get beyond this fantasy that just leaving things alone will allow the economy to self correct and return everything to some imagined equilibrium.
Posted by: 2slugbaits at October 21, 2010 02:40 AM
Carl Lumma: Bank reserves and U.S. T-bills are very much regarded as equivalent assets from the point of view of the private sector. That's the essence of the problem we currently face: if the Fed buys T-bills with newly created reserves, nothing changes.
Reserves and T-bills are also very much equivalent liabilities form the point of view of the unified balance sheet of the Treasury and the Fed. The Treasury pays interest on T-bills and the Fed pays interest on reserves. It is true that this interest rate at the moment is very low, so you might think that the Treasury doesn't really owe anything. But if interest rates rise, the Treasury would find those liabilities are very real indeed. For exactly the same reason, reserves are not just an accounting liability of the Fed. It is true that at the moment the Fed only needs to pay banks a very low interest rate to persuade them to hold them. But if conditions change, the Fed could not allow those reserves to get into circulation as currency without creating your hyperinflation. If interest rates rise, the Fed would face exactly the same kind of challenge in persuading banks to hold reserves as the Treasury would face in persuading its creditors to roll over their T-bills.
So reserves and T-bills are virtually equivalent assets for the public and virtually equivalent liabilities for the government. That, I repeat, is the essence of the current challenges with using monetary policy to help the economy.
Now for your comments on our paper. "Satiation point" refers to a situation in which the value of the liquidity services provided by reserves is zero. It does not mean, as you seem to suppose, that demand for reserves equals zero. Banks are indifferent between holding reserves and T-bills. Demand for reserves equals $1 trillion and it would equal $2 trillion if the Fed wants to buy another trillion dollars worth of something.
Our position is not that the Fed hasn't tried to change expectations but that it hasn't succeeded.
Posted by: JDH at October 21, 2010 05:27 AM
I appreciate your assertion, but you provide no evidence or reasoning.
If prices need to fall to be honest prices, that is what should happen. I mean honest in the sense that they express accurately supply & demand.
Where is the example of the non-self-correcting downward spiral of deflation? Japan's problem can hardly be described as deflation. Their current CPI=99.5, pretty much the same as it was in 1993. In 1990, when the collapse began, it was 92.5. The AVERAGE price has been roughly flat for 20 years. Their problem was/is they had masses of bad debt, which they've attempted to paper over. We are in the same place & doing the same thing.
Posted by: Bryce at October 21, 2010 06:32 AM
Carl Lumma: "An increasing inflation rate lowers all interest rates in the economy, including those on consumer debt."
I realize that's the standard wisdom among economists, but it seems to me it rests on the fallacy that inflation is always similar among all prices AND wages.
Let's assume Joe six-pack has a 4% auto loan. Core CPI rises 2%, just as the Fed would like, but the headline CPI is up 3% because commodities are rising disproportionately faster. Meanwhile, Joe's wages increase only 1%, because the business he works for is seeing its margins squeezed as its costs increase faster than the prices it charges.
True, a slightly smaller proportion of his wages are spent on servicing his loan, but it is more than made up by increased share devoted to gasoline, groceries, etc.
Since you bring up the market's response to news of the Fed's intentions, doesn't it seem to have spurred much more job-creating investment in emerging markets than in the U.S.? That will help support commodity prices, which are essentially a tax on the American worker.
There is a real arrogance among economists making predictions about QE2. That's why Stiglitz's piece was so refreshing.
Posted by: Bob_in_MA at October 21, 2010 07:20 AM
I suggest reading Lacker's latest speech which subtly suggests why QE wont help stimulate GDP, and only cause greater currency debasement and higher asset prices, especially commodities... most interesting is the Obamacare and other regulatory bills which are causing unemployment to be elevated... I can personally attest to a recent attempt of mine to hire a secretary (college educated) who turned me down bec she preferred working as a nanny/housekeeper for cash despite this not advancing her career and resume (her husband was in the backoffice of a major brokerage firm and hence she had healthcare); her rationale was that even my total comp offer (about $100k, incl benefits) was not as good as working $20/hr for cash about 4 days per week (she cited: no deductions, no taxes, much more flexible hours) ... oh, and she was collecting unemployment benefits as well (which were recently extended by our dysfunctional congress) .. do the math, she is right ...
Posted by: ASG at October 21, 2010 07:24 AM
I have trouble understanding what you see in Scholes remark unless it means a version of the other basic objections, which are fear that somehow action could backfire. What safer assets exist? We saw short term yield go negative because they are the safest. If the question is about the pricing of the long part of the curve, then I'm not sure that's an objection.
It seems to me that if you're going to argue fear, then you're really saying that fear should cause inaction. This is an interesting reflection of FDR's "the only thing we have to fear is fear itself" because now the argument is that we need to fear fear.
Why is fear a reason? I haven't read anything that speaks clearly of how the Euro would collapse, which sounds like nonsense given that the you'd have to construct a chain of events, a cascade really, in which European exports collapse. In that regard, anyone hear of Germany? They're doing quite well at exporting. And as you note, it's not like the Euro is fixed.
There is a rational fear of deflation and a rational risk associated with it. Where is the evidence that action will cause inflation to run out of control? currency collapse? It sounds more like being afraid of the clothes in the closet because in the dark they look like ghosts.
Another problem I have with the fear idea is that it is also used to promote action when that is the politically desired result. Fear of the short-term deficit is used to inspire the idea that we must contract spending now, even as we are then told that we need to add to the deficit through extending tax cuts - but not the withholding tax reduction passed under Obama that expires at the end of the year, directly reducing consumption. I point out that contradiction - cut now to avoid a problem that is not especially severe given the reduced state of collections versus actually making the problem worse - to note that fear causes these contrary impulses.
Posted by: jonathan at October 21, 2010 07:29 AM
FX: "And regards to the yield curve, central banks of their perspective country CAN ALWAYS MANAGE THE CURVE AT WILL(after all, they primarily expand money base by creating new money and buying bonds, it's what they are set up to do, functionally)"
Au contraire: Our excessive rates of inflation (especially since 1965), has been due to an irresponsibly easy monetary policy. Our monetary mis-management has been the assumption that the money supply can be managed through interest rates
Between 1965 and June of 1989, the operation of the NY Fed’s “trading desk” has been dictated by the federal funds “bracket racket”. Even when the level of non-borrowed reserves was used as the operating objective, the federal funds brackets were widened, not eliminated.
Ever since 1989 this monetary policy procedure has been executed by setting a series of creeping, or cascading, interest rate pegs.
This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to costless legal reserves, whenever the banks need to cover their expanding loans – deposits.
We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.
The effect of tying open market policy to a fed Funds rate is to supply additional (and excessive, & costless legal reserves) to the banking system when loan demand increases.
Since the member banks seldom operated without any excess reserves of significance (since 1942), the banks had to acquire additional reserves, to support the expansion of deposits, resulting from their loan expansion.
Apparently, the Fed’s technical staff either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2 -1/2 percent, and all other obligations in between.
This was achieved through totalitarian means; involving the control of total bank credit and the specific rationing of that credit we had official price stability and “black market” inflation.
The production of houses and automobiles was virtually stopped, and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort. This plus controls on prices and wages kept the reported rate of inflation down.
Financing nearly 40% of WWII’s deficits through the creation of new money laid the basis for the chronic inflation this country has experienced since 1945. Interest rates, especially long-term, would have averaged much higher had investors foreseen this inflation. This was reflected in the price indices as soon as price controls were removed.
There were recently 5 interest rates (ceilings tied to the Primary Credit Rate @.50%), that the Fed could directly control in the short-run; the effect of Fed operations on all other interest rates is still INDIRECT, and varies WIDELY over time, and in MAGNITUDE.
It is an historical fact. The money supply can never be managed by any attempt to control the cost of credit (i.e., thru interest rates pegging governments; or thru "floors", "ceilings", "corridors", "brackets", etc). IORs simply exacerbate this operating problem. I.e., Keynes's liquidity preference curve is a false doctrine.
As long as it is profitable for borrowers to borrow and commercial banks to lend, money creation is not self regulatory. This observation would be valid even though the Fed did not use the federal funds bracket device as a guide to open market operations.
With the use of this device the Fed has actually pursued a policy of automatic accommodation. That is, additional costless reserves, & excess reserves, were made available to the banking system whenever the bankers and their customers saw an advantage in expanding loans. The member banks, lacking excess reserves, would just bid up the federal funds rate to the top of the bracket thus triggering open market purchases, free-gratis bank reserves, more money creation, larger monetary flows (MVt), higher rates of inflation – and higher federal funds rates, more open market purchases, etc., etc.
Posted by: flow5 at October 21, 2010 07:53 AM
JDH Wrote: "If interest rates rise, the Fed would face exactly the same kind of challenge in persuading banks to hold reserves as the Treasury would face in persuading its creditors to roll over their T-bills."
The only reason this statement even approaches a degree of truth, is because the FED is so feckless. The Central bank can change reserve and capital requirements at will. The Treasury, on the other hand, can not by fiat compel all its creditors to roll-over their treasury securities. At the point that support of the dollar as a reserve currency (access to the US import market) exceeds trade profits, Treasury security purchases will dry up. As a matter of fact, that is exactly what has been going on for the last three years. To plug the hole, the FED has stepped in to provide market support.
Posted by: MarkS at October 21, 2010 07:53 AM
Bryce:We are talking here about the overall price level, that is, the number of dollar bills needed to buy a bag of potatoes. I do not understand what you mean by honest prices. I would think any sensible description of the equilibrium price would involve the supply of dollars and the supply of potatoes. Since the Fed controls the supply of dollars, how can you think of the dollar price of potatoes as something determined independently of the actions of the Federal Reserve?
Posted by: JDH at October 21, 2010 08:25 AM
QE2 encourages FINANCIAL investment as opposed to REAL investment.
For example if the debt was acquired to finance the acquisition of a (1) (new-security), the proceeds of which are used to finance plant and equipment expansion, or the construction of a new house, rather than the purchase of an (2) (existing-security) or to finance the purchase of an existing house (read bailout), or to finance (1) (inventory-expansion), rather than refinance (2) (existing-inventories).
The former types of investment are designated as (1) "real" as contrasted to the latter (2), which constitute "financial" investment (existing homes).
Financial investment provides a relatively insignificant demand for labor and materials and in some instances the over-all effects may actually be retarding to the economy.
Compared to real investment, it is rather inconsequential as a contributor to employment and production. Only debt growing out of real investment or consumption makes an actual direct demand for labor and materials.
Posted by: flow5 at October 21, 2010 08:36 AM
You said reserves getting into circulation may lead to hyperinflation. Do you mean using those reserves for consumption/investment spending. If so, that spending would be income/profits to some entity. Since income/profits are taxed, the reserves would be mopped up through taxation long before hyperinflation set in (especially with so much slack in the global economy). If you mean reserves would be loaned out, banks don't make loans based on reserves anyway. Just look at the many countries with zero reserve requirements. How do those countries banks make loans if they have near zero reserves. Banks make loans based on credit worthy borrowers. Reserves can always be obtained after the fact. Preventing hyperinflation from excessive borrowing must always be contained through regulation, not reserve requirements.
Posted by: markg at October 21, 2010 09:03 AM
I think Bryce may live in a world where the potato supply might change.
But obviously we can't let that happen in our real world.
Posted by: Cedric Regula at October 21, 2010 09:30 AM
Cedric Regula: Of course the potato supply changes all the time. But how does anything about the supply of potatoes give you a theory of what the "honest" inflation rate should be?
Posted by: JDH at October 21, 2010 09:57 AM
flow5: thanks for the long write-up, but I am quite aware of the historical events. However, my focus was on the yield curve alone - the central banks can always monetised regardless of the (lack of) buyers. Secondly, the current situation we are seeing in bond yield reflects this (Morgan Stanley, etc, worked out which part of the curve that benefit the most from POMO, with the current flavour being the 7 yr range). Third, fed can't set the real market interest rate, all it can do is set its fed fund rate, and manipulate yield curve and hope to damp/clamp/boost the real market interest rate.
Another way to think about is like this: during the good times, the real market interest rate is actually low due to competitive forces, while fed fund rate can be much higher (like 3-5%). While in a slump, the fed fund rate can be low, but the real market interest rate is clearly much higher (banks aren't lending is a clear sign for this, for given risk/reward).
I don't think we are actually disagreeing though - seems to be a small misunderstanding. I do firmly agree fed has been hugely irresponsible in creating bubble through easy money.
Posted by: FX at October 21, 2010 10:47 AM
I agree. A reverse poll tax would be better than QE2. Now, about implementing it ...
"Since the Fed controls the supply of dollars, how can you think of the dollar price of potatoes as something determined independently of the actions of the Federal Reserve?"
I thought the problem was that the Fed controls only the amount of reserves, which do not necessarily get turned into dollars. Isn't the issue whether the Fed can get banks to reduce excess reserve holdings by the right amount, to generate the desired supply of money (and hence price level)? But it is not a smooth, continuous process. Banks may decide to hold increased reserves with no effect on the money supply until the excess reserve pool is massive (as it is now). Then, if the banks all decide to divest themselves of excess reserves at once, the money supply and price level may jump much more than desired. Isn't that the problem? And isn't the problem also that to generate such inflation (or to just prevent deflation) the Fed must succeed in convincing the market that inflation will occur, now or in future, despite continuing excess capacity and high unemployment? Announced price targetting may work, but it depends entirely on how it affects the expectations of market participants. In other words, mind games. This seems like a very dodgy game to me.
Posted by: don at October 21, 2010 10:56 AM
Personally, I don't think potatoes should inflate, unless you make them into french fries and can charge for your value added due to market demand for french fries.
But any more complex analysis than that is probably a subject for an entire economics book. Maybe even more than one.
Posted by: Cedric Regula at October 21, 2010 11:14 AM
JDH:"We are talking here about the overall price level." I'm NOT talking about the overall price level. As I unsuccessfully tried to convey, I'm talking about RELATIVE prices.
The many things that are sensitive to artificially cheap credit [money lent that has never been saved but created out of thin air] will respond with price moves that misleading to all economic actors. Commodities, investment assets, things that people buy with borrowed money, etc. are bid up in price, causing mistakes about their fundamental demand. Consumer goods are initially unaffected. Resources are mistakenly diverted away from consumer goods & towards those things made attractive by artificially low interest rates.
QE inadvertently misallocates resources.
Posted by: Bryce at October 21, 2010 11:28 AM
Bryce: OK, my apologies. I thought you were claiming that deflation was natural and that having the Federal Reserve prevent deflation was unnatural.
Posted by: JDH at October 21, 2010 11:39 AM
You can't believe we have monetary induced deflation?
Posted by: Cedric Regula at October 21, 2010 11:49 AM
Cedric Regula: Of course not.
Posted by: JDH at October 21, 2010 11:51 AM
My comments were only intended to clarify that there is nothing dishonest, inappropriate, or distoring about the Federal Reserve trying to prevent deflation. Apparently I was misunderstanding Bryce's point, if he and others were in fact never making any such claim.
Posted by: JDH at October 21, 2010 11:55 AM
Remember Greenspan's irrational exuberance speech back in 1996?
Shortly after that speech the Fed released a simple formula showing stock investors how to value the stock market. It showed an inverse proportion between stock prices and short term interest rates.
Then time passed and Greenspan seemed to disregard that his nifty formula may also apply to housing prices and bond prices.
Many people refer to these things as "distortions" caused by Fed actions. And Greenspan thought he was fighting deflation.
Posted by: Cedric Regula at October 21, 2010 12:50 PM
But do you think monetary induced deflation is possible?
Posted by: aaron at October 21, 2010 12:54 PM
aaron:"But do you think monetary induced deflation is possible?"
If it's me you are asking, I say yes. It was under a gold standard. Then even with fiat currency, Milton Friedman said the money supply had to grow enough to keep up with population growth and productivity growth, else price deflation would be the result.
Of course if you mean did we grow money and credit too much lately and blew up the economy as a result, resulting in deflation...yes we did do that.
And the 1930s fear of deflation that modern economist suffer from was that falling prices led to business being unable service debt, resulting in bankruptcy, job loss and a failing financial system. Then we had to wait for Creative Destruction to work full cycle, which takes a long time.
This is why Ben and Company are so intent on reflating China and saving them from this terrible fate.
Posted by: Cedric Regula at October 21, 2010 01:15 PM
Reserves and T-bills are also very much equivalent liabilities form the point of view of the unified balance sheet of the Treasury and the Fed. The Treasury pays interest on T-bills and the Fed pays interest on reserves.
Huh?? The Treasury pays interest on bonds but it also repays the par value.
IOR is a new policy and, unlike with bonds, the rate can be changed arbitrarily.
...reserves are not just an accounting liability of the Fed. It is true that at the moment the Fed only needs to pay banks a very low interest rate to persuade them to hold them. But if conditions change, the Fed could not allow those reserves to get into circulation as currency without creating your hyperinflation.
Hyperinflation occurs only when the rate of inflation exceeds the rate of real growth. It is far from clear there is any latent danger of that.
So reserves and T-bills are virtually equivalent assets for the public and virtually equivalent liabilities for the government. That, I repeat, is the essence of the current challenges with using monetary policy to help the economy.
The Fed has unlimited power to create inflation, through the mechanism I already described. ZLB constrains conventional monetary policy, not QE.
Demand for reserves equals $1 trillion and it would equal $2 trillion if the Fed wants to buy another trillion dollars worth of something.
You haven't established that. You're also ignoring that the IOR rate is arbitrarily adjustable, ignoring very strong market responses to the QE2 announcement,* and ignoring everything else I said.
* Don't take my word for it, your colleague just posted: "What is interesting is that the dollar is weakening against other currencies, including the East Asian currencies. Much of the depreciation has occurred as talk of QE2 has mounted."
Our position is not that the Fed hasn't tried to change expectations but that it hasn't succeeded.
They haven't succeeded because money has been too tight throughout the crisis. Had they committed to some kind of targeting rule things might have been different. Nobody seems to know why they didn't. One thought is that they like to practice a bit of creative destruction from time to time. That's something they could never admit to and hence one possible reason why they want to remain secretive about their process.
Posted by: Carl Lumma at October 21, 2010 03:14 PM
Good answers, I did mean the question for Dr. Hamilton, but it's open and appreciated.
I think I misunderstood the discussion when I asked. What I meant was, do you believe monetary easing could result in deflation?
I'm thinking it may. I think we might be in state similar to what Krugman describes here, but where the resulting expected increase in cost of living and the price distortions of easing drive up uncertainty and the need for savings and makes investment in production unlikely.
Posted by: aaron at October 21, 2010 03:23 PM
Bryce QE inadvertently misallocates resources.
This is a strange argument to advance unless you are denying that what we already have today is a massive misallocation of resources. I look at the prolonged output gap and all I see is misallocation of resources, so it's a little hard for me to get excited about a bump in inflation in the wake of QE2. It's perfectly proper to worry about misallocation of resources when the economy is operating at full potential, but in the current context that concern just seems sadly misplaced.
Posted by: 2slugbaits at October 21, 2010 03:28 PM
In other words,
The anticipated, yet unpredictable, price distortions cause uncertainty and make people save more. This slows money and causes deflation/disinflation.
Posted by: aaron at October 21, 2010 03:34 PM
Another risk it tis. If OPEC doesn't like the fiat currency race to the bottom, an oil field begins to look like a pretty good bank vault. So Krugnam pointed out that under the right market conditions, restricting supply may get you more gross income.
Also China has a big hole in the ground they want to fill with oil.
But along the same lines, we have a bunch of "necessities" we may have to spend much more money on. Energy, carbon, healthcare, taxes. Also accumulating savings takes much longer under ZIRP, and even longer if all these propped up manipulated markets correct for any reason.
So that will feel like deflation for any industries whom are not recipients of this redirected cashflow.
Posted by: Cedric Regula at October 21, 2010 03:51 PM
Even if wages are sticky, returns on existing obligations matter to investors. See my NYT comment.
Posted by: Carl Lumma at October 21, 2010 04:29 PM
In addition, I think our unseriousness in determining the true extent of our reserves or pursuing our known reserves is a clear indication that we do not believe alternatives will become viable competition for fossils. If we thought alternatives could compete, we'd be extracting like crazy to sell it while it's still valuable. (With the exception of perhaps just prepping our easiest reserve to keep as long term emergency reserves.)
Posted by: aaron at October 21, 2010 06:21 PM
The misallocation of resources that we now experience results from Greenspan/Bernanke's 1% rate [exacerbated by other central banks, esp. PBoC]. Like Bernanke currently, they were trying to paper over the recession that resulted from the Dotcom bubble, which in turn was permitted by loose money in the 1990s. (Rising investment demand in the 90s would have driven interest rates higher, thereby choking it off before the bubble had Greenspan had any insight.)
We are just doing it again & will get the same result. Perhaps this eventual reality will be more convincing than my ineffective words.
Bad debt needs to be dealt with directly & honestly, not hidden & bailed out by the innocent. The guilty should pay & the prudent pick up the pieces.
Instead, retirees & insurance companies suffer reduced incomes & are forced to put their savings into risky vehicles so that reckless bankers don't pay for their recklessness.
Posted by: Bryce at October 21, 2010 06:56 PM
Kocherlakota made such a claim not too long ago, arguing as follows:
"Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case –0.75 percent."
He was roundly chastised (and ridiculed) for confounding cause and effect.
Posted by: don at October 21, 2010 07:07 PM
A question noone has been able to answer satisfactorily. How can anyone expect inflation to top 5% with the median wage declining? What is it about QE2 that's going to increase the CPI? I just don't see where working and middle-class households are going to get the incremental dollar needed for inflation. Sure, gasoline and other commodities may increase, but I expect other products' prices to decrease, as the extra dollar going to fill the gas tank will not be available for apparel.
Posted by: Paul at October 21, 2010 07:49 PM
Bryce Whether or not we got into the Great Recession because of Greenspan's & Bernanke's 1% rate is debatable, but it's an irrelevant point. We're not doing an autopsy on how we got here; the problem at hand is how to move away from the threat of deflation. In his London School of Economics lectures Paul Krugman made the point that Austrians are in the habit of forever mistaking autopsy for prescription. I think you're making that same mistake here. You are also betraying another Austrian trait, and that is the feeling that the economy must be punished with more economic pain as the price for getting out of a recession. This sounds a bit too medieval for my tastes. The point of macroeconomic policy ought to be to ameliorate conditions and soften the business cycle. We don't need economists who just urge more self-flagellation and more purgatives in order to release the bad humors.
Posted by: 2slugbaits at October 22, 2010 02:09 AM
Your short-run focus damns us in the long run. How can you prescibe without understanding of the disease?
Posted by: Bryce at October 22, 2010 08:49 AM
2slugbaits: "Your short-run focus damns us in the long run. How can you prescibe without understanding of the disease?"
How is the prescription for economic weakness induced by malinvestment caused by artificially cheap money even more malinvestment caused by artificially cheaper money?
Do you think there are a wealth of productive projects languishing for want of cheap finance?
The commenters on this forum and the two professor-authors talk about inflation and deflation as if they are the thing and the whole of the thing that matters for policy, but they are only indicating states of affairs in the underlying economy. It is the drivers of price changes that are important, not the mere fact that prices change.
Attempting to fight deflation by causing inflation is missing the point. Inflation and deflation are not two ends of a spectrum except in a superficial sense, and it's possible to generate inflation and simply exacerbate the misery caused by deflationary pressures.
Is there a reason QE is expected to accomplish more than that?
Posted by: Rodrigo at October 22, 2010 01:11 PM
"Bad debt needs to be dealt with directly & honestly, not hidden & bailed out by the innocent. The guilty should pay & the prudent pick up the pieces."
Couldn't agree more.
"Instead, retirees & insurance companies suffer reduced incomes & are forced to put their savings into risky vehicles so that reckless bankers don't pay for their recklessness."
Well, to do this, I think the Fed would need to let those same retirees and insurance companies accept some huge losses (compared to present valuations), probably equal to many times their present annual losses in interest income. The Fed is following a policy of trying to please the people by supporting overvalued asset prices. This may well turn out to be a bad idea, as I think we agree was it's policies after the dotcom bust.
Posted by: don at October 22, 2010 04:20 PM
Can we agree that the main goal of QE1 and QE2 is to repair bank balance sheets?
Policy makers can spin it any way they want to, but the bottom line is that trillions of dollars of ~free money is available to the big investment banks via the FED. A small fraction trickles through to the goods producing economy but the bulk is put to work at the big banks' trading desks.
Recall the business model that broke the big investment banks. Borrow shorter maturity and lend longer maturity. The big investment banks have simply brought their broken business model from outside the FED umbrella, (pre-lehman), to under the FED umbrella (post-lehman).
All this nonsense about expectations and negative real rate incentives is little more than a distraction.
As proof, look at the financial markets. They rarely trade on fundamentals anymore. Policy decisions that reflect the ease with which big investment banks can expect to obtain money is what's moving the markets. This expectations driven effect is not spurring investment in plant and equipment, it is only spurring trading profits.
Posted by: tj at October 22, 2010 10:02 PM
tj "Can we agree that the main goal of QE1 and QE2 is to repair bank balance sheets?"
No, we cannot agree that is the main goal. The main goal of QE2 is to defang the threat of deflation and to restore a moderate but healthy rate of positive inflation. One of the Fed's goals is price stability, and deflation is not consistent with that goal. Deflation tends to be sticky, so it tends to manifest itself in lower output rather than just further reductions in the price level. That's why a little bit of deflation is a lot worse than a little bit of inflation.
If QE2 is successful and it is able to bring inflationary expectations up to (say) 3%, then that will make it more costly for banks to just sit on reserves earning 0.25%. QE2 will have a new twist to the old Operation Twist...it will bring down the medium term interest rate, which should encourage private sector investment.
While I support the Fed's flirtation with QE2 and I think they should go ahead with it, I am under no illusion as to what we can expect it to accomplish. Most of the heavy lifting should be done through fiscal policy, but QE2 is likely to be helpful at the edges. Just because the Fed cannot solve all of our economic problems is not a reason for them to at least do what they can.
Posted by: 2slugbaits at October 23, 2010 07:58 AM
okay, so it the impact on big investment banks an unintended consequence or an intended consequence?
Also, can you please explain the transmission mechanism from excess reserve creation to inflation (money based, not commodity based) when we already have an excess of excess reserves?
Why should anyone raise their inflation expectations with so much excess capacity in the economy?
You and Menzie always use the output gap to argue against expansionary policy igniting inflation. How does QE2 stave off deflation given the large output gap and the puny demand for loanable funds?
It's obvious to me that FED easy money is going anywhere the primary brokers/banks want it to go. Under the current environment, it is not getting into the real economy, where output and jobs are created.
I am not sure why you can't see this. Your ideology seems to be clouding your perception of reality.
Posted by: tj at October 23, 2010 10:58 AM
Damn you climate disruption! This cold and heat and floods and drought could have been avoided if the republicans would not have blocked the progressive agenda.
Posted by: tj at October 23, 2010 07:00 PM
The bond vigilantes have called interest rates higher …. and currency traders have called the Euro lower in response to the Federal Reserve’s QE 2.
The “bond vigilantes” took action on October 7, 2010 and called the Interest Rate on the 30 Year US Government Bond, $TYX, higher, resulting in the 10 to 20 Year Govenment Bonds TLT falling lower.
It was later on the October 15, that the” currency vigilantes” came to the market, and called the Euro, FXE, lower, in response to increasing concern over the Death’s Star Debt Monetization.
The 10-22-2010 chart of the Euro, FXE, shows a broadening top pattern with close at 138.78, down from its October 14, 2010 high of 140.22. It’s like Street Authority communicates: When you see the broadening top, the market will eventually drop.
QE II is Debt Monetization and that is destructive to stock wealth.
Yahoo Finance shows the EUR/JPY traded up slightly to 113.38.
I provide the chart of FXE:FXY trading up to fisish in a black lollipop hanging man candlestick. One can see the red lollipop hanging man candlestick on October 6, 2010 at 116; this was the euro yen carry trade setting up to move the Euro lower on October 7, 2010.
It was an unwinding euro yen carry trade that moved the European Shares, VGK, lower on October 15, 2010 form 51.59 to 51.35.
Neoliberal economist Milton Friedman introduced floating currencies. The era of profiting from borrowing at 0% interest from the Bank of Japan, and investing long in carry trades, started to be over April 26, 2010 with the onset of the European Sovereign debt crisis. October 6, and October 15, are simply nails in the coffin of a previous prosperous age. We have entered into an age of austerity and hardship.
Setyo Wibowo, of the Forex Instructor, relates: ”The EURJPY attempted to push higher yesterday, topped at 113.92 but found resistance at the upper line of the bearish channel as you can see on my h4 chart below and closed lower at 113.05″. The ActionForex.com report reads bearish at 113.27: “EUR/JPY’s recovery was limited at 113.92 and weakened again. Intraday bias is turned neutral for the moment. Fall from 115.56 is viewed as a correction in the larger rally from 105.42 only and hence, even in case of another fall, we’d expect downside to be contained by 111.44 support and bring rally resumption.”
Of significant note, this week’s Yahoo Finance value of the EURJPY 113.92 is less than the Yahoo Finance Value of 114.40 of 10-15-2010 suggesting that the currency traders are selling the euro yen carry trade in response to higher sovereign interest rate on the US 30 Year Government bond and falling 30 Year US government bond values and falling 10 to 20 Year US Government Values, TLT.
The primary reason the US Federal Reserve is coming out with QE 2 is to sustain the value of the US Government Notes, SHY, and the value of the shorter duration US Government Bonds, IEF. And so far, its efforts have seen success as the Interest Rate On The 2 Year US Government Note, $UST2Y, has fallen to 0.35%.
The Fed’s QE, communicated through Fed Governors, and through Pacific Investment Management Company, and presented in summary form by EconomicPolicy Journal, has maintained the value of Pimco’s Mint, MINT, Mortgage Backed Bonds, MBB, the Intermediate Bond Funds, GSUAX, and Annaly Capital Management, NLY, as well as distressed investments, FAGIX.
Note the contrast seen in the chart of the longer out US Government Debt, TLT, and its October 7, 2010 fall.
Theyenguy says: “The US Federal Reserve and the currency traders have scorched the Investment Skies, welcome to the Investment Desert Of The Real, we ain’t living in Kansas no more, we are living in a new Investment Matrix, and I hope you interpret the code correctly, and invest in gold, its one’s only protection one has in a debt deflationary bear market.”
Posted by: theyenguy at October 23, 2010 08:59 PM
I would submit that the real response from QE2 comes from those who manage other people's money (asset managers), since they have a much shorter investment time horizon and have very asymmetric risk/reward profile. If Fed drives down yield on Treasuries, bond fund managers just have to buy into more risky issues to reach for yield or risk investors withdrawing funds and losing AUM (and therefore pay for the managers). This will reflate existing asset. But how is this going to generate consumer credit when consumers are worried about future job prospect? How is it going to generate new business investment when business combinations funded by cheap money are mainly intent on reducing payroll and taking out production capacity? No matter how cheap the money is, consumption or investment in money losing businesses are still negative return activities. Thus I don't see how this really affects the real economy now that liquidity is no longer the problem.
Posted by: H.Z. at October 23, 2010 10:05 PM
First, as I tried to make clear in my earlier reply, I do not have a lot of confidence that QE2 will work. And for many of the reasons you cited, such as the puniness of the likely QE2 effort relative to the magnitude of the output gap as well as the apparent insensitivity of investment spending to the interest rate. So I am by no means trying to oversell QE2. It's effects are likely to be marginal. That said, a marginal improvement is better than no improvement and a marginal uptick in inflation is better than continued disinflation or deflation. The Fed needs to do what it can even if its scope of action is limited.
You asked for the transmission mechanism whereby QE2 would be helpful. There are lots of different ways to answer this using different models, but I think the easiest and most intuitive is to think about how the Fed influences the money supply in normal times. Normally the Fed influences the money supply by adjusting the spread between short term assets and monetary base. But when short term rates and monetary base are, for all practical purposes, perfect substitutes, then the Fed cannot play with this spread because one doesn't exist. What the Fed is talking about now is to start playing with longer term interest rates that are not substitutes, which would (in theory) give the Fed the same kind of leverage between medium term rates and monetary base that the Fed had during normal times between short term rates and the monetary base. I think Brad DeLong has a nice explanation that is more or less along these same lines:
Posted by: 2slugbaits at October 24, 2010 06:34 AM
2slug: "Stuff about QE2"
What you wrote is a textbook answer devoid of content. Think about potential mechanisms for whatever inflation is delivered by QE2.
Moderate, healthy, short-term demand-pull inflation could be a product of prices being pulled up by rising wages. In the current environment of excess capacity this might even manifest itself as higher output before it showed up as inflation.
However, QE2 is unlikely to directly affect wages except for bankers. QE2 is much more likely to inflate commodity prices, and through them create cost-push inflation. This merely makes most members of the economy poorer, so we can't argue from this mechanism.
Of course, QE2 could spur the creation of real wealth (which could raise wages) by lowering medium to long-term interest rates and lowering the return to saving. If you believe there is a backlog of profitable projects that would be funded but for the attractiveness of parking money in no-risk paper assets, this could be the explanation for you.
Unfortunately, in an environment where money is virtually free the low-hanging fruit - projects with favorable risk profiles and good ROI - will have been funded anyway. Projects that are funded because QE has decreased the marginal price of cash will also be marginal. Thus QE fuels malinvestment in projects that would not have been considered but for the lack of profitable alternatives. That's not going to get us robust real wealth creation, so this mechanism won't work either. In fact, to the extent this DOES happen, QE is setting us up for another fall later.
It's worth considering that bankers and financiers are not stupid, and that part of the reason monetary policy has not made more of a splash in the real economy is that lowering the cost of money doesn't make backing a losing project look any more attractive, and all projects look more risky in a rocky economy.
Finally you might appeal to the expectations mechanism, but this is totally ephemeral positivist BS that conflates peoples expectations about "inflation" with their expectations about conditions in the real economy. Raising people's expectations about inflation independent of genuine economic improvement, if the Fed can accomplish it at all, is just going to induce people to abandon the dollar as a viable store of value.
What am I missing here? Very smart people take QE2 seriously and at face value, but the mechanisms by which QE2 could function don't seem to inspire that kind of confidence.
Posted by: Rodrigo at October 24, 2010 07:28 AM
I'm not so sure "deflation" would be bad. Energy prices still have not come down to pre-bubble levels. I see it as a necessary price adjustment. It only become prolonged disinflation/deflation when the adjustment fails to happen quick enough.
Posted by: aaron at October 24, 2010 07:50 AM
Here's what I took away from this article..
1) The most effective QE would be to print cash and buy goods/services with it. IE: Fiscal stimulus.
2) Failing that, next-best is to alter prices in the bond market (by buying long bonds) such that risky assets are priced closer to riskless assets so that risky projects are more likely to get funded.
3) What we're doing now is merely altering the maturity structure of the US debt, which creates some money through the treasury carry trade but ultimately does not move the needle in the real economy.
Would you say that's an accurate summary of DeLong's argument?
Posted by: Rodrigo at October 24, 2010 07:51 AM
Rodrigo A bit of a crude summary, but it probably captures the gist. The first choice would be fiscal policy, but it could be financed through Treasury borrowing rather than directly monetizing the debt. As to the second option, most QE2 advocates are only talking about altering the purely temporal part of risk and not risk in the sense of a project failing; however, DeLong is going beyond that and is looking at more than just the pure time factor. And this leads to your third point about QE2 not moving the needle. As I've said several times, I don't expect QE2 to move the needle very much, but that is not a reason for not trying.
If you don't think QE2 will do the job, then write your congress critter and demand more fiscal stimulus. Unfortunately, the same people who are demanding cuts in spending are the same folks complaining that we shouldn't do QE2 because it won't be effective. And then you get inane comments like the one from aaron saying that deflation wouldn't be such a bad thing and ought to be welcomed as a way of purging the economic system of accumulated rot. Liquidate! Liquidate! Liquidate! aaron apparently believes that deflation is a convergent process that will restore some kind of equilibrium. aaron should study up on something called a Fisher relation. As Krugman points out, in a liquidity trap with deflation the aggregate demand curve is likely to be locally upward sloping, which means that a reduction in price reduces output. It's a divergent process, not a convergent one.
Posted by: 2slugbaits at October 24, 2010 08:43 AM
2slugs and Rodrigo,
Thanks for the constructive dialougue--cogent and erudite and for one non-schooled in this field, highly illuminating as to how your framework is pieced together. Any thoughts regarding a currency crisis and at what point QEx would cause that to happen? Us unwashed masses might be getting a wee nervous at the sums being tossed around, and the impact on our "savings."
Posted by: Rob at October 24, 2010 12:17 PM
I find the whole conversation about QE2 quite academic. What people are confused about is the situation of the average American. Right now the average American is way over their head in debt or unemployed. I see that if inflation rises then people will buy today instead of tomorrow. The problem which is that people don't have the money to buy today and with job losses and very low raises they won't have the money tomorrow either. While this may be good for businesses it will be catastrophic for many Americans. Food, Energy and basic day to day costs of living will rise and push many people who are currently surviving into bankruptcy. More bankruptcies mean more foreclosures. I wish the powers that be would actually consider what QE2 will do to a person instead of a company.
Posted by: Confused at October 26, 2010 11:28 AM
Thanks for the link. I didn't mean to criticize QE2, I was just saying that the Treasury didn't have to wait for the Fed or get permission from Congress.
I think you take Scholes's argument too seriously. I think it is unreasonable to assume that individuals consider their share of risk born by the Fed. This is Ricardian equivalence on steroids. I think it is clear that no one knows how much risk the Fed is bearing. In fact, I'd guess that most people don't have the sense that the Fed is bearing more risk now than it did in 2006.
As you and Wu note (I guess) the income tax, in effect provides insurance. If risk born by the Federal Government increases uncertainty about income tax rates, it doesn't terrify me. I'm afraid of the case in which I won't pay more to cover the Feds losses, because my income will be low.
Scholes, like all other economists, can't explain the equity premium. If people invest too little in risky assets because they don't know how to diversify (or don't know how much difference it makes) forcing them to bear risk as citizens can make them better off.
He assumes Keynes is totally wrong. If the Federal government bears risk it runs large deficits in recessions and surpluses in expansions. If Keynes had a point such automatic stabilizers are good.
The risk in sub-prime mortgages was not just still there. It was concentrated on the books of financial firms including Lehman and AIG. The fact that it wasn't diversified doesn't mean risk can't be diversified. The risk in the dot com bubble was still there too (and similar in scale) but it didn't cause as much damange.
Basically Scholes is assuming that everyone has rational expectations and diversifies optimally, that markets work perfectly, and that everything is for the best in the best of all possible economies. Then he concludes that, under those assumptions, QE2 won't improve things. Knock me over with a wrecking ball.
Posted by: Robert Waldmann at October 28, 2010 06:46 PM