Sailing QE2 around Charybdis

By Felix Salmon
November 3, 2010
official Fed statement lays it out quite plainly: the economy is struggling, and needs all the help it can get; meanwhile, inflation is lower than the Fed would like to see. Since rates can't be lowered below the zero lower bound, all that's left is QE.

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It’s easy to see the logic behind the Fed’s latest bout of quantitative easing. Indeed, the official Fed statement lays it out quite plainly: the economy is struggling, and needs all the help it can get; meanwhile, inflation is lower than the Fed would like to see. Since rates can’t be lowered below the zero lower bound, all that’s left is QE.

The Fed, on this view, has precious few tools at its disposal, and so its using the tools it has as best it can, in pursuit of its mandate. Right now, unemployment is way too high—and the longer it stays that way, the more structural it will become. The Fed can’t simply hire millions of people, so instead it’s buying up hundreds of billions of dollars in Treasury bonds, and hoping that the proceeds from those purchases will somehow find their way into expanded payrolls. It’s never been tried before, so no one has a clue whether it’ll work. But not trying it is simply defeatist, an admission that there’s nothing the Fed can do to boost employment.

What’s the downside? Well, for one thing, it’s extra fuel for the bond-bubble fire. Treasuries are already highly sought-after securities; this announcement increases the demand for them so much that the Fed has had to “temporarily relax” the limit of 35% of any given bond issue that it’s allowed to buy. With all that money flowing into a constrained asset class, market imbalances are all but certain to result in unintended consequences somewhere down the road.

What’s more, the Fed has historically spent relatively little time worrying about the dollar—that’s Treasury’s purview. And the first-order effects of a looser monetary policy are in fact positive: a weaker dollar means higher export revenues and therefore more money for hiring new employees.

But there are all manner of nasty second-order effects; indeed, my colleague Jennifer Ablan talks about quantitative easing as “exporting currency chaos.” It now costs essentially nothing to borrow dollars, and to then take those borrowed dollars and use them to buy other currencies, like the Brazilian real, which yield vastly more. That’s the carry trade, and it can be very destructive: it means massively overvalued currencies in places like Brazil, and when it unwinds (it always unwinds) it tends to do so in a very messy and destructive manner. (Remember Iceland?)

More generally, the Fed is spending trillions of dollars on an experiment, with no real plan for what to do if the experiment goes wrong. Indeed, it’s far from clear that the Fed has spent much time war-gaming the various different scenarios of how QE could go pear-shaped, and what it might be able to do in response.

Certainly one of those negative outcomes is a sudden bout of untamable inflation if and when the economy gets out of its current slump: after the Fed has printed all that money, the other shoe can drop fast. Too-high inflation at some point down the road isn’t probable, but it’s possible, and its likelihood is surely higher now than it was before the Fed’s balance sheet started expanding faster than the Very Hungry Caterpillar.

But there are other negative outcomes too. And in general, the further that the Fed goes down this path, the less control it has over the economy and the money supply. Which means more of that uncertainty which everybody is blaming, these days, for the very slump the Fed is trying to get us out of. You can see how QE, however logical and well-intentioned, might end up being counterproductive.


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We have current real problems – unemployment and a slow economy. The dangers are, in your words, possible, not probable. Not dealing with real problems because of speculative dangers doesn’t sound like the optimal strategy.

If things get out of hand, the Fed can reverse course and raise rates.

Increased fiscal spending would be better, but our political system is too broken for that to happen. QE2 is the best available alternative.

Posted by 3oosion | Report as abusive

When a bond matures, the buyer gets all of his principal back, right? So if the average duration of these purchases is 5-6 years, doesn’t that mean the Fed will take the bulk of this money back out of the economy in that timeframe? How can this add to long-term inflation?

Posted by nedofbaker | Report as abusive

The Fed’s logic is simple, and the need to keep playing the QE card irresistible, from their standpoint. It goes like this:
“We tried it before, and it didn’t quite work, sadly. Not trying it again would be admitting that we failed, and that we are clueless. So let’s keep playing the game, and see what happens…”

Call it irresponsible? Indeed it is.

Posted by yr2009 | Report as abusive

I see this a bit differently…

We are coming off thirty years of almost non-stop economic boom, and as a result have a large bill to pay. By the time all is said and done, both margins and earnings will be compressed for all market participants. Corporations will see lower profits (and heavily leveraged businesses will fail). Individuals will see lower wages. Unemployment? It will be with us until the wages fall to the point that hiring American labor/business is cheaper than importing.

I don’t like that assessment any better than you do, I just don’t see any way out of it. Whether you call it a “depression” or a “business cycle” or a “correction”, it is likely to be brutal.

Now these are some serious deflationary pressures. That’s a hard “answer” for an economy that is already carrying a very high level of credit. Either you end up with a massive round of defaults/foreclosures (if the banks can ever find the original notes they supposedly put in safe-keeping) or you generate inflation to devalue the debt. The wealth destruction for savers/retirees occurs either way, but inflation is less disruptive than the collapse of the entire financial system.

Thus the Fed has to find a way to produce inflation despite an economy that is screaming for deflation. They might prefer a more modest rate of inflation (perhaps 3% to 5%), but at this point they’ll take whatever they can get. And if they keep trying hard enough, EVENTUALLY they should be able to succeed.

Posted by TFF | Report as abusive

If you want to spend money to reduce unemployment, why not get a load of construction workers going on infrastructure?

Simplistic I know, but physical infrastructure will still exist long after a bond bubble has burst, and there are plenty of unemployed construction workers available.

Is this just too, well, Keynsian for anyone in the US to contemplate? Or is it too focussed on blue collar builders rather than wall street?

Posted by Dafydd | Report as abusive

The good news is surely they are done effing up the world.

Posted by minipaws | Report as abusive

Yet again the same falsehood that if businesses have extra money they will expand and hire more people. If there is no/low demand for a business’s product they will not expand and will not hire. Just like giving the banks a bunch of extra money will not in itself stimulate lending. If there are little to no people wanting to borrow money there won’t be any lending. So where does all this extra money go? Big bonuses for these CEOs who are doing such and excellent job.

Posted by Waubay | Report as abusive

It’s hard to believe a buncha bright guys with degrees can sit around and honestly think that printing money is the answer. All that cash will end up in bank reserves and/or invested in Treasury bonds, certainly not in the real economy. Expanded payrolls? It is to laugh at such naivete.

Mr. Hoenig has it right; this whole QE II business is ill-advised and will backfire, badly, at some point.

If any finger-pointing is required, best to aim at the White House, where fiscal policy – if indeed there is ANY fiscal policy at all in the Obama administration – resembles a massive train wreck.

Posted by Gotthardbahn | Report as abusive

Inflation, is actually not very low – around 2 percent. And even this figure is “saved” by the rather weird way the Fed accounts the “core” inflation. I wonder what exactly are the mechanisms the Fed is hoping for. Since no reasonable person could hope for another real estate bubble to employ people I can see only one – through depreciating currency and exporting inflation to other countries. Smart, of course, the problem is that that is exactly what the 30s crisis was all about: countries acting unilaterally and trying to “export chaos”. The US has lost their card in the multilateral discussions: she can no longer point at others calling them “currency manipulators” since they are doing the same. I think now all emerging markets feel that their reluctant attempts to introduce capital controls have been justified and will do it with a renewed zeal… The ECB will be the last to fall. But they will. Remember, in the 30s it was the same. It was Germany, which refused to participate in the FDRs global inflation strategy, and, as a result, closed their trade down, relying on bilateral trade agreements. History rarely repeats itself but if countries base their actions on flawed economic concepts and misunderstood historical experience – it does.

Posted by tk2 | Report as abusive

This is non an experiment. It was done in the 1980s in exactly the same manner by the Soviet Union, and you all know how it ended. I see no reason it won’t bring the same catastrophoc collapse in America too. There is no Kaneysian mechanism implemented, neither will be with the current GOP majority in the Congress, to guide all the money from QE to a consumption, so commodities’ cost will double, and hence we will end within 6 months with extreme material costs and lowered demand for goods. That means higher unemployment, personal bancrupcies all over and hyperinflation. The house market has another 60% down, in my opinion, unless the inflation spikes first – which I never have seen historically. Great Depression number 2, my guess, almost for sure now, is coming spring 2011. Cheers!

Posted by Ananke | Report as abusive

There have to be some very smart, very well-informed people out there looking at this issue. So why are we seeing all this negative, finger-pointing, hand-wringing, weeping-and-wailing over the Fed policy?
Why aren’t we seeing better/fresh/different ideas or approaches being reported on and discussed in the media? Is it because NOBODY out there HAS a clue or a better idea of what to do?

If so, that is even scarier than what Bernanke is doing. Bernanke is either a genius or the dumbest guy on the planet. Either way, until the verdict is in, I’ll bet we see no change in employment, job growth or any other economic indicators that might point to better times.

Hunker down folks, it looks like it is going to be a very rough ride…

Posted by stanrich | Report as abusive

tk2, commodity inflation is picking up some steam HOWEVER that is only part of the CPI. Wages (and the cost of services) aren’t increasing at all, and will continue to stay flat as long as unemployment is high.

Rising costs (at least for material goods).
+ Flat wages
= Hard times

Posted by TFF | Report as abusive

“commodities’ cost will double, and hence we will end within 6 months with extreme material costs and lowered demand for goods. That means higher unemployment, personal bankruptcies all over and hyperinflation.”

While true to some extent, it is the “material goods” that will be most impacted by the higher material costs. At this point our domestic economy is heavily slanted towards services. Inflation will result in reduced wealth (as goods will cost more) and reduced demand for goods (as people will not be able to afford as much), but I’m not sure that translates into another wave of domestic unemployment.

Rather, I would expect unit imports to decrease. The dollar value of imports might actually INCREASE, but simply because each unit costs more.

Posted by TFF | Report as abusive

TFF – to explain simply: $4-5 a gallon and most of the American households will be underwater, regardless the service based economy. That will be the soonest thing happen, and I mean in a month or two, and we will be very lucky if the prices just stay at $4-5 levels.

“Green economy” doesn’t exist in America :), and even if high energy costs make it feasable, it will benefit Chinese companies and create almost zero employment in the US.

Either FED is crazy, or they are pumping inflation in China to break the yuan peg, targeting political unrest there. This is very very dangerous game…

Btw, Wall Street transactions go towards “Services” in GDP, but apparently that doesn’t translate into positive news to the average person. Neither are postive the GDP “services” in the ever rising healthcare costs…The average American just affords neither or less of these services, but statisticly they are increasing share in GDP, since their cost is rising with double digit % annually…And please people don’t just focus on “unemployment”, it means nothing. You may have low unemployment and decreasing income, which was America for the last couple years.

My point is that FED initiated money pumping, and there is no meaningful fiscal policy. All these printed money will just pour into capital and commodity markets, when the US economy is structurally consumer based. With effectively regressive income taxes, it will correspond to even higher deficits – hence the effect will be stagflation.

Posted by Ananke | Report as abusive

Make us more competitive with lower corporate rates, like Singapore. Gives us a multiple year tax credit for each new employee hired. Give tax incentives for foreign corporation to start manufacturing here, instead of going away. Impose a tax, or make it less tax deductible to outsource labor. Impose tariff on finished goods from country that do not have adequate labor laws. The jobs will come back and inflation too, ultimately curing the debts.

Posted by robb1 | Report as abusive