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The coming depression blog | April 20, 2019

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Monetary policy, Full speed ahead

THE ocean liner Queen Elizabeth 2 was launched in 1967 to throngs of excited spectators. Expectations are considerably lower for the Federal Reserve’s launch of monetary QE2: a second round of quantitative easing, the purchase of bonds with newly printed money. Critics have already predicted it will be either ineffectual or dangerous.

Undeterred, the Fed has moved ahead:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The announcement of $600 billion in new purchases is slightly above the $500 billion level many anticipated but the 8 months over which they will be purchased is longer, so the monthly pace of $75 billion is a bit less than expected. In what may be disappointing news to some, the Fed has not changed its language to signal a move toward an official inflation or price-level target. Still, the early evidence suggests that QE2 is already working as advertised. Since Ben Bernanke, the Federal Reserve chairman, hinted in late August that it was on its way, financial markets have responded vigorously.

The 10-year bond yield has fallen from 2.65% to 2.53%. At the same time, expected inflation, as measured by the inflation-indexed bond market, has risen steadily. This means that real yields on ten-year, inflation-indexed Treasury bonds has fallen from 1.05% to 0.5%. Indeed on October 25, the Treasury Department sold five-year inflation-indexed bonds with a negative real yield for the first time.

Lower real yields also raise the value of future profits, and that has helped drive stock prices 13.5% higher. And easier monetary policy has made the dollar and dollar investments less attractive; the dollar has fallen 4.4% against the yen, 9.7% against the euro, and 5% on a trade-weighted basis. “You can declare QE to be a success already”, says one hedge fund economist. “Whether this translates into real activity remains a question mark. But the question of whether the mechanism would work has been answered.”

In theory, this should help the economy through three channels. First, lower real yields spur borrowing and investment. This channel, however, is partly blocked: households can’t borrow against the depreciated value of their homes, banks have tightened underwriting standards, and businesses are waiting for sales to pick up. The remaining two channels are not similarly impaired. Higher stock prices have raised household wealth, which should spur spending and offset some of the damage of lower home values. And the lower dollar ought to help trade. Indeed in October, American factory purchasing managers reported a sharp jump in export orders and a drop in imports.

Macroeconomic Advisers, a consulting firm, reckons that if this round of QE eventually adds up to $1.5 trillion that should be enough to raise growth next year to 3.6% from 3.3%. That’s not exactly overwhelming. Larry Meyer, the firm’s vice-chairman, thinks the Fed would have to buy $5.25 trillion to achieve the equivalent of a negative 4% federal funds rate that today’s economic slack actually demands. The Fed won’t go that far; it worries too much about unintended consequences. It would also invite attack from some of Congress’ newly empowered Republicans. In a Bloomberg poll, 60% of self-identified Tea Party supporters favoured overhauling or abolishing the Fed.

Could QE succeed too well, by driving expected inflation up to dangerous levels? “The odds aren’t zero,” says Don Kohn, a former Fed vice-chairman, but they’re small. There’s slightly more risk that expectations could rise once credit loosens up and spending accelerates. That, however, would be a signal that the Fed has succeeded; it can then tighten policy.

Another potential cost is that by driving the dollar down, QE merely shifts the burden of growth to other countries, perhaps fueling asset bubbles in their markets in the process. Some of this is may be unavoidable. Countries with overheating economies need to tighten monetary conditions, either through higher interest rates, a rising currency, or both. The central banks of both India and Australia raised interest rates this week despite sharply higher currencies. China has grudgingly allowed its currency to creep higher recently, and this week central bank officials hinted they will have to tighten monetary policy soon.

By far the most interesting response, however, has been the Bank of Japan’s. It had planned to announce details of its own QE programme at a regular policy meeting on November 15-16. But it abruptly accelerated the date to November 4-5. This seems to reflect a desire to counteract any boost to the yen resulting from the Fed’s announcement. The action risks aggravating tensions over currency levels, but it could have a more benign effect. “This kind of follow the leader response by central banks is part of the solution and not part of the problem”. says Barry Eichengreen of the University of California at Berkeley, who has long argued that such competitive reflation is analogous to the expansionary effect of quitting the gold standard in the 1930s. If Mr Bernanke’s is the face that launches a thousand ships, the global economy may be the better for it.

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