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.