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QE2: Background

By on 11.9.10 @ 1:57PM

Prominent Republicans Sarah Palin and Rep. Paul Ryan disapprove of the Federal Reserve’s new $600 billion round of quantitative easing (QE2), citing dangers ranging from “permanently higher inflation” (Palin) to “destablizing” the investment outlook (Ryan). They may be right, but there is a strong case for QE2 that I don’t think they fully appreciate. So here is my attempt, for which I make no promises, to explain what Ben Bernanke and company are trying to do, and a look at some of the pros and cons involved. 

The Fed has a dual mandate: to promote a high level of employment and to maintain a stable price level. As the recession has worn on, unemployment has remained near 10 percent — a disastrously high level. While inflation remained low and stable, Bernanke and the Fed seemed reluctant to try to spur job growth using monetary policy. Now, however, the employment outlook is increasingly dire, and inflation is trending below where it needs to be for price level stability. Accordingly, Bernanke and company have decided to try to increase inflation to the usual 2 percent, with the idea that doing so will boost employment in the process.

The key to understanding Bernanke’s logic is that unemployed resources such as labor and capital put deflationary pressures on the economy. In wildly oversimplified terms, there are too goods and services chasing too few consumer dollars, leading to an increase in the value of dollars.*

Here is the trend of disinflation/deflation that Bernanke is seeing, as reflected in two common inflation measures: 

Although the volatility introduced by swings in the price of gas and food somewhat obscures the trend, you can see that by late 2010 both measures are approaching 1 percent — 1 percent below the 2 percent Bernanke is looking for. 

So will the Fed purchasing $600 billion more Treasurys generate runaway inflation and the collapse of the dollar, as feared by Palin and Ryan in addition to National Review, Cato, and other right-wing commentators?

Possibly. But while I am no Bernanke apologist, I think that there is a real need to prevent deflation and to try to boost economic activity by expanding the Fed’s balance sheet, and that inflation — in the short term — is not as pressing a concern as unemployment is. 

Recent history suggests that injecting another $600 billion into the economy will arrest the downard trend of inflation without sparking uncontrolled inflation, but do little to speed up the employment recovery.

What is the evidence all that money won’t lead to massive inflation? Oversimplifying again, QE2 is nothing more than a $600 billion expansion of the Fed’s balance sheet. A similar expansion enacted at the height of the financial panic in 2008 (namely, QE1) did not stoke inflation.

This graph, taken from the Cleveland Fed, shows the size and composition of the Fed’s balance sheet over the recession. QE1 is the obvious discontinuity starting in September of 2008 (click on the picture for a larger image):

And this graph provides a look at two measures of the broader money supply, M1 and MZM:

Note that there is no spike in the broader money supply corresponding to the increase in the Fed’s balance sheet in 2008. And also note that the graph shows the money supply clearly stagnating toward the end of 2010. 

For the Fed to create inflation, it would have to increase the money supply. Remember Milton Friedman’s famous formulation: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Without a spike in the broader monetary aggregates, such as M2 and MZM, short-term inflation is not likely. By expanding its balance sheet as the recession put downward pressure on the money supply, the Fed has kept M2 and MZM to normal growth — until the recent leveling-out.

(A caveat: QE1 mostly comprised purchases intended to stabilize financial institutions, not to ease monetary policy, and the Fed began paying interest on reserves, a contractionary move, around the same time as QE1.)

So the Fed’s rationale is this: as the unemployment crisis lingers on, with consumers hesitating to spend, businesses holding off on hiring and investing, and banks not lending as they should, the economy is experiencing disinflationary pressure. To counteract that, the Fed will incentivize spending by increasing the cost of holding money. The Fed increases the cost of holding money by raising the price and lowering the yields of Treasurys, and increasing inflation, which lowers the value of cash. 

What are the possible drawbacks to QE2? One is that the economy could surge, leaving the Fed in a tough position to unwind without letting inflation expectations get out of hand. In a very long and wide-ranging argument, John Hussman presents another critique: “It is difficult to interpret Bernanke’s defense of QE2 as anything else but an attempt to replace the recent bubble with yet another - to drive already overvalued risky assets to further overvaluation in hopes that consumers will view the “wealth” as permanent.” E21 presents a case that QE2 is misguided because it is predicated on boosting consumer activity, which is an unlikely source of further recovery. 

QE2 represents a dramatic intervention in the capital markets. I think it’s fair to say that the ultimate effect of QE2 is hard to predict, and there are bound to be unintended consequences. Bernanke has decided, reasonably I believe, that, given the ongoing disaster of soaring unemployment, the benefits of QE2 will outweigh the costs.  

* It’s widely believed that deflation hurts the economy more than commensurate inflation, all else equal, for reasons related to the makeup of businesses’ balance sheets. So for inflation hawks wondering why the Fed sets a 2 percent inflation target instead of 0 percent, the answer is that a little inflation is better than a little deflation. If the Fed misses its target and inflation ends up lower than intended, as it is now, the economy won’t slide into deflation.

View all comments (29) |

around the track| 11.9.10 @ 2:36PM

There are many intepretations of what Friedman would have said about the Fed's actions and this article offers a partial one. In my opinion, the best source is his presidential essay for the American Economic Association in 1968. Read it and it will be clear he would conclude today that Bernanke, in all due respect to a very fine economist and a dedicated public servant, is like a
little boy playing with matches out in the yard during a drought.

ncatty| 11.9.10 @ 2:52PM

The Fed toolbox is empty. Time for fiscal and regulatory action by Congress. Stop spending, don't raise taxes, and resist more regulations. When the debt pig passes all the way through the python, our economy will take off. It will take more time and more pain, but it will happen barring Congressional missteps.

Sean| 11.9.10 @ 2:59PM

This is all about devaluing the dollar and monetizing the debt. This is nothing short of a huge tax increase by an unelected semiprivate entity on the American people. No one is buying treasuries so the FED is going to print money and purchase them ? If people don't wake up to this scam fast we are going to find ourselves in Mexican Peso territory soon. No wonder gold and other commodities are hitting record highs.

Ryan| 11.9.10 @ 3:06PM

Of course, this hurts those of us who would much rather save before we purchase - and do anyway.

Derek Leaberry| 11.9.10 @ 3:16PM

Mr. Lawler ignores the morality of the situation. Printing money in this way is also a way to enable generational theft. What the American people deserve is to have their lifestyles diminished so that the money they stole from the future can be paid back. America needs to stop spending and to stop creating money out of thin air.

KML| 11.9.10 @ 3:20PM

QE2 is madness. Two things can be done that will spur unprecedented economic growth and lower unemployment. It is a no brainer. Repeal Obamacare and the banking regulation bill. There is PLENTY of money out there. Companies are sitting on a trillion or more, and the American citizens are sitting on about two trillion. The problem is the government. There are two 2000 page bills that were passed, and no one, not even the idiot senators and congressmen and women who passed it, know what is in them. We have only been given a taste of how taxes, insurance, and who knows what else is going to go up. Companies have no idea, so instead of using the trillions of dollars to expand, grow, and hire people, they are sitting on their money because no one knows what is in the bill, or worse yet, how the government will interpret the vague language that was found in the bills. Political uncertainty is keeping unemployment and growth where it is. Repeal it all! Until then, Bernanke, Obama, et al will slowly destroy the country.

Jeff Perren | 11.9.10 @ 3:30PM

The only useful thing the Federal Reserve could do for the country is to gradually remove itself from the economy. They've been one of the root causes of every major recession and depression in the United States since its creation.

Flooding the market with billions more in fiat money is exactly what they've always done to contribute to them, and this time will be no difference.

The author's perspective is literally mystifying given that it appears on American Spectator.

Oldefarte| 11.9.10 @ 3:31PM

What is unsaid by Palin and Ryan is the probably POLITICAL MANIPULATION by our current governmental administration to attempt to lower the unemployment rate. Their fiscal non-stimulus was solely intended to maintain state/local municipal employment in order to benefit their governmental labor union political allies, not to provide any stimulus. Since same naturally failed in its stated economic purpose and unemployment is still at the 10% level and not decreasing, this administration has now placed its political pressure [Chicago style] on Bernanke to alternatively attempt to use his monetary policy mechanisms to do what their fiscal policies failed to accompolish. That is why Palin, Ryan and many financial authorities [ie Germany's minister] are so alarmed at this unwarranted printing of dollars to facilitate the purchasing of Treasuries. It will explode inflation, it will not decrease unemployment [which cannot be forced upon businesses but will only result from their having confidence in the government's economic policies, which it does not], and will be detrimental to this country's [and possibly to the world's] economy!!!!!

JimH| 11.9.10 @ 3:39PM

Debasing the currency will ensure employment at the wheel barrow factories. See pictures from the Wiemar republic.

Grzmlyk| 11.9.10 @ 3:40PM

So why are fuel prices and grocery prices going up?

Chuck| 11.9.10 @ 3:48PM

Ladies and Gentlemen it is time for the American people to move on the FED and eliminate it. An act of Congress (1913) created it and another act of Congress will remove it. The existence of central bank printing money is UNCONSTITUTIONAL. Congress has the authority to COIN money meaning a return to gold and silver coins ONLY as United States currency. The value of the dollar has dropped 99% since 1913, 25% in the last decade. The FED is a bank where interest paid to this bank is TAX FREE. This madness has got to stop or we will end up like the Weimar Republic. To his credit JFK tried to circumvent the FED by printing then circulating debt free US Treasury notes in lieu of debt ridden Federal Reserve notes, the amount printed equaling the value of silver but his death ended this and all US Treasury notes were removed from circulation.

Cris Worth| 11.9.10 @ 3:52PM

Also in 1965 Congress further debased the currency by removing silver from dimes, quarters and eventually half-dollars replacing silver with base metal.

Ryan| 11.9.10 @ 4:07PM

Didn't we have a Great Depression on the Gold standard? Didn't we have the greatest boom of our economy off of it?

All currency is fiat. Don't forget that.

Gold is far too limited in supply and use, and you can't eat it when times go bad.

Chuck| 11.9.10 @ 6:27PM

How do you explain $14 trillion dollars in debt? When FDR took us off the gold standard the Great Depression got worse; dittos for Nixon's wage and price controls which eventually accelerated inflation. The current FED chief said the Federal Reserve was responsible for the Great Depression. How revealing is this? Disobeying the constitution has gotten this country into serious trouble revival begins by terminating the most powerful egregious institution ever devised by mankind, the US Central Bank aka Federal Reserve.

Ryan| 11.10.10 @ 8:16AM

I'm not opposing you on the Fed here, just the idea that the gold standard is the end-all be-all of economic stability and growth.

The Great Depression got worse because of multiple factors, NOT because we got off the gold standard. The Fed was one, increased spending another, lack of a free and transparent market on Wall Street a third.

Jeff Perren | 11.10.10 @ 11:30AM

"Gold is far too limited in supply and use, and you can't eat it when times go bad."

Neither can you eat paper bills or electronic entries. Are you suggesting it would be preferable to use agricultural products as currency?

No, gold is no panacea - the economy is complex. But it is historically a well-respected, widely used store of value, one for which many will trade bread, milk, etc.

Jeff Perren | 11.10.10 @ 11:34AM

Addendum:

And, no, all currency is not fiat currency. "Fiat" does not mean simply selecting a standard by convention or market forces. It means making that selection arbitrarily, creating money out of thin air (i.e. not backed by wealth created). Only the government (or a con man, temporarily) can do that. It's illegal when the con man does it; it should be illegal when the government does it.

PattyMor| 11.9.10 @ 4:55PM

The recession and tepid recovery are all government induced. The Fed can't create jobs; it can't compel business to create them (yet); Obamster can't create them.

You have Obamster shutting down drilling, farming, mining, manufacturing due to onerous regulations. QE2 isn't going to change this and it isn't going to stop the government spending.

The alarms bells are going off in the form of commodity prices. The government is spinning out of control. We are at the edge of the abyss.

I have my food supply ready. My husband won't let me buy a gun. Be prepared.

Meanwhile Obamster, his family, and entourage party on the deck of the Titanic.

Occam's Tool| 11.9.10 @ 6:28PM

In moments of crisis, best to quote the Classics:

"It's astounding, time is fleeting
Madness takes its toll
But listen closely, not for very much longer
I've got to keep control."

Sounds like the Obama administration is taking its cues literally from Riff-Raff.

[I hate explaining jokes, but the quote is from "The Time Warp," a song from The Rocky Horror Picture Show, and the character singing the song is named Riff-Raff. I'm aware that some readers here are much more erudite than me, and never went through the metal detectors to attend a midnight screening at the NuArt.]

chris mahoney | 11.9.10 @ 7:52PM

I wish more conservatives and libertarians would pay more attention to Scott Sumner's themoneyillusion, where he makes a complelling case for Bernankean outcomes targetting, i.e., nominal growth. Suboptimal employment ultimately leads to socialist solutions, and should therefore be avoided, quite apart from the moral aspect (fathers and moms without jobs).

aware| 11.10.10 @ 5:58AM

"...try to increase inflation to the usual 2 percent, with the idea that doing so will boost employment in the process."....If this nonsense is true then would more inflation lead to more employment? Why not hyperinflation to achieve full employment? A perfect example of the bankruptcy of modern economic theory.

And then this "...to try to boost economic activity by expanding the Fed's balance sheet".....refer to your own chart #2. With the explosion of the Fed balance sheet in '08/'09 we would have had the greatest economic boom in history if this was true. More idiocy.

You do not seem to understand that the Fed is the reason we have lost control of government. It provides all the "money" needed for government to grow, in spite of revenues. It, not the government, utterly controls the economy. It drives the boom/bust cycle with arbitrary interest rate setting, sending false signals and causing credit induced bubbles. The only victim now seems to be the US government, as most wise people are trying to pay off debt not acquire more.

Deflation that we are seeing is the result of asset prices that are too high, which is itself a result of Fed policy.
Defend this stinking mess that enslaves millions in debt while enriching a select few, that funds the State with instantly created "money", that creates massive bubbles through credit expansion followed by devastating busts that bankrupts the unwary while saving the henchmen, that spreads misinformation by putting its cloven hoof first on one side of the scales then the other, all you want.

But the Fed is a bloated black spider that sits at the center of a web of corruption. This will not end well and a year or two from now even you will see how destructive it really is. A real shame this has to appear in this venue. It would fit better in the Economist.

axbucxdu| 11.11.10 @ 12:57PM

"the Fed is the reason we have lost control of government. It provides all the "money" needed for government to grow, in spite of revenues."

The core problem, and clearly explained in just twenty five words.

JFGalt| 11.10.10 @ 8:02AM

QE2 is just kick the can. We should have left the banksters to fend for themselves for their stupidity instead of rewarding them with bailouts and bonuses. I also think the author here has forgotten the Fed's real mandate - that is to protect the major banks that OWN the Fed. Does he remember of even know that the Fed is not a government agency? The first and second central banks in this country failed and the last one was so corrupt that it purposefully caused economic panic out of revenge against a president that understood that the central bank was just a banksters tool for legalized theft. Get rid of the Fed and just pass financial laws that actually protect the citizens of this country.

Dale Cord| 11.10.10 @ 12:45PM

Most of the population of our country is suffering under the delusion that the Republicans are for the American people. There is no difference between these two UN-AMERICAN POLITICAL PARTIES, who have been fleecing the citizens of this country now since Woodrow Wilson's Communist regime took root in Washington. Being uneducated in history and politics is no shameful thing considering, our educational system is being controlled by the political machine in Washington and abroad. What is shameful though is to remain in a state of mental confusion as to who our enemy really is in this country. To focus your mind on entertainment though, instead of who is violating the sanctity of your freedoms, livelihood, home and privacy as an American citizen is the epitome of shameful stupidity. Your bible and history books have a multitude of warning signs for your survival in this world of predators. Who seek not only your income but your very soul. If you really want what is best for your loved ones, and true God given freedom and equality for all in America. Then open your eyes and unlock your mind and let truth, set you free. The removal of both the Democrat's and Republican's in this great country of ours would be a great start. Read our Constitution for the legality and authorization by the people to do this or, remain subjects and cannon fodder to the warlords and criminals who rein over us at this present time. "There is a way that seems right to a man but, the end therein is Death"

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