Friday, August 26, 2011

How QE3 Could Help

With Bernanke's speech today at Jackson Hole, QE3 is in the news. Yesterday Izabella Kaminska at Alphaville wrote about the Fed's use of Jedi mindtricks -- its influence on market expectations -- and rightly noted that one of the important impacts of any additional QE would be its effect on market expectations. Agreed.

But a couple of times now she has made reference to her belief that QE3 "might only prolong the liquidity trap or make it worse." I'm trying to understand the argument, and I'm not sure that I get it. When I hear the term "liquidity trap", I think about a situation (like the present) in which nominal short-term rates have been pushed down to zero, so conventional monetary policy has no impact on the economy. By selling short-term assets and buying long-term assets, how exactly would a new round of LSAPs by the Fed make the liquidity trap worse?

More generally, I have yet to see a convincing argument for why QE3 would be a bad idea (in the previous post I explained why I find Woodford's arguments unconvincing, for example), and I can see a couple of ways in which it might help.

1. Market expectations. First, as Kaminska and others have pointed out, additional QE (or LSAP, which is the more accurate name) could have an impact on market expectations. But that's a good thing. Anything the Fed can do right now to communicate that it will do work hard to avoid further disinflation, and that in fact it is willing to tolerate a bit of inflation, will help to spur new spending.

But I think it's just as important to remember the rather prosaic but very real impact that further QE would have on long-term interest rates. As I've summarized before, there are a number of rigorous empirical studies that show that the Fed's QE programs had a significant impact on long-term interest rates. And if QE can push long-term interest rates down, it can have additional positive impacts on the economy through a couple of channels.

2. Help push investors out of US Treasuries. For one, driving down long-term Treasury rates will, at the margin, push some investors who have been parking their cash in government bonds to move their wealth into other assets. Anything that persuades investors to take on a bit more risk, undertake new investments, and lend money to businesses and individuals has to be a good thing. (Yes, this is another way of saying that QE pushes down interest rates throughout the economy, not just in the market for US Treasuries.)

3. The housing market. Perhaps more importantly, lower long-term interest rates lead directly to lower mortgage rates. And mortgage rates have a well-established and signficant impact on the housing market. (See, for example, this 2008 paper by Clayton, Miller, and Peng (pdf) for some recent empirical estimates of the impact of mortgage rates on house prices and transaction volumes.) Since the housing market is probably the sickest part of the US economy right now, and is certainly a serious drag on economic growth (as highlighted by Bernanke in today's speech), there's every reason to think that pushing down long-term interest rates could have some real positive effects on the economy.

So yes, Jedi mindtricks are important, but there are other mechanisms through which QE3 could have a real, positive impact on the US economy. It would not be a miracle cure, of course, but it would have a positive impact at the margin. And at this point, we should be happy to take whatever we can get.


  1. orlando_lassus9:23 AM

    <p><span>Did QE1 and QE2 “work”?<span>  </span>How’s the current mix of GDP, unemployment and inflation look to you?<span>  </span>What makes you think another round of QE will yield different results?</span>
    </p><p><span>There was a time when policy makers and other intelligent observers understood that markets are properly a reflection of the state of the economy and not a means to control the economy.<span>  </span>Our political and policy leadership has become obsessed with satisfying “market expectations” to the detriment of all of us.<span>  </span>These expectations are nothing more that the demands of powerful individuals and organizations for actions that will directly benefit them.<span>  </span>Do not confuse the satisfaction of market expectations with actions that are good for the economy. </span>
    </p><p><span>Our current interest rate environment has dramatically curtailed income to those holding bonds and CDs.<span>  </span>On the consumption side, the retired and elderly would be spending a lot more if their savings could generate reasonable interest income. <span> </span>Lower rates of return are requiring many public and private organizations to reduce spending and lay off workers in order to fund pension and other actuarial commitments. <span> </span><span> </span></span>
    </p><p><span>I sure am glad the Fed is willing to “tolerate” more inflation.<span>  </span>Of course, as a worker, tolerating inflation is possible only if you have a job with an employer who can/will increase your salary to compensate for the loss of purchasing power.<span>  </span>I wonder if the majority of working age citizens in this country is in a position to tolerate more inflation. <span> </span>[And this doesn’t get into what role QE may have played in the food protests and riots around the world over the past few years.] </span></p>

  2. orlando_lassus9:26 AM

    Part 3 (sorry for the reverse order - should have posted differently)

    <span>Lower rates will entice businesses to borrow?<span>  </span>Rates are already so low that a few more basis points are virtually irrelevant to a company’s borrowing decision.<span>  </span>Businesses are not investing (borrowing and spending) because there is a global glut of supply and a lack of demand.<span>  </span>Lower interest rates are not going to change that.<span>  </span>I would also note that 1) banks have no shortage of funds to loan – what they lack are credit-worthy borrowers who wish to borrow, and 2) many large and mid-size companies are currently sitting on piles of cash that could be used to fund expansion without the need to borrow. <span> </span><span> </span><span> </span><span> </span>

    “there's every reason to think that pushing down long-term interest rates could have some real positive effects on the economy”.<span>  </span>There is so much wrong with this statement I don’t even know where to begin.<span>  </span>And so I won’t except to say that citing Bernanke, with his track record, is not going to inspire confidence in the assertion.</span>

  3. Ken Houghton7:28 PM

    You want higher long-term rates?  Announce that the Fed's inflation target is 4% (Most of the MMT folk would prefer 6%, since they're targetting 5% NGDP, but that's a side issue), effective immediately, and will remain there until at least 2013 or when the Employment-Population Ratio is again above 62 (which was the level of 8/2008--during the recession--so this is not asking for a "full recovery"), whichever comes first.

    Possibly, in combination with stopping paying interest on excess reserves, you might get a result from monetary policy.  (Not betting that way, but--as Captain Kirk said in ST II--"It has the virtue of never having been tired.")  You'll also get several failed banks, but that should have happened in 2008/2009 as well.

    At least it might get rid of the strange delusion that the retired and elderly "<span>would be spending a lot more if their savings could generate reasonable interest income."</span>