Sailing QE2 around Charybdis

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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