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October 2012

Is The Fed Going Old School With QE3?

The U.S. Federal Reserve recently announced its latest round of monetary stimulus, dubbed "QE3," which it hopes will support the economy through open-ended monthly purchases of mortgage bonds. This latest program represents a significant shift in monetary policy. However, it may actually bring monetary policy closer to the conventional approach used from the mid-90s through late 2008. If so, it has a higher likelihood of helping to provide traction to the U.S. economy than the previous QE programs.

The Fed has been flanked by criticism for its actions. From one corner, critics argue that the previous rounds of QE, "Operation Twist," and a fourth consecutive year with short-term interest rates near zero have proven that the Fed is virtually powerless to stimulate economic growth and hiring. This contingent claims QE3 further increases the risk of inciting runaway inflation and cautions that policy makers should instead address the fiscal and structural issues facing the U.S. economy from the bottom up.

In the other corner, critics contend the Fed's previous programs have not been bold enough, and that even more extreme measures are called for. Last month at the Fed's annual convention in Jackson Hole, Wyoming, for example, noted economist Michael Woodford presented a paper endorsing a "nominal GDP target path" to guide Fed policy. The emergence of nominal GDP (NGDP) targeting as a topic at Jackson Hole touched off a celebration by some of the lesser-known economists who have been championing the concept for several years. Rather than concede that the Fed is powerless, proponents of NGDP targeting contend that the Fed's previous attempts at QE have been ineffective because no one — outside the Fed, and perhaps even within it — really understood how and to what degree the programs' fixed dollar amount of bond purchases would end up impacting the economy. In order to make quantitative easing effective, they argue, households and businesses must expect the easing will be effective. To create this expectation the Fed must credibly tie its future actions directly to its targets, such as inflation, unemployment, and/or nominal GDP.

In his remarks following the announcement of QE3, Fed Chairman Ben Bernanke seemed content that the Fed's newest program struck the right balance to keep both sides at bay. While he expects QE3 to help drive growth without creating inordinate risk, he conceded that the Fed's actions would be limited in their impact, and that more help is needed on the fiscal side. We see QE3 as a significant shift in policy, one that brings it closer to the approach advocated by Woodford and other supporters of NDGP targeting, while avoiding some possible pitfalls of that untested policy regime.

A Peek Inside The Fed's Policy Toolkit

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Policy Tool QE2, Operation Twist QE3 NGDP Targeting
Method The Fed purchases a fixed amount of government and/or mortgage bonds within an announced schedule. The Fed commits to purchasing a fixed monthly amount of mortgage-backed securities (MBS) and government bonds without specifying an ending date or total amount it may ultimately spend. Nominal GDP is simply the output of the U.S. economy measured in dollars, before adjusting for inflation. To target NGDP, the Fed promises not to increase interest rates until NGDP increases toward some pre-announced growth path. The Fed is supposed to be indifferent as to whether this nominal growth is the result of inflation or real factors such as productivity increases.
Intended policy transmission mechanism Put downward pressure on longer-term interest rates, inducing households and businesses to fund risky investments and projects instead of hoarding cash, thereby boosting growth. Put downward pressure on longer-term interest rates, but with open-ended commitment and explicit focus on employment that links the program more directly to its outcome, with the hope of reinforcing the credibility of its commitment. Convince households and businesses that the Fed will hold rates low until nominal GDP approaches its target, in effect promising them high real returns on money invested today.
Results assessment When announcing these programs, the Fed did not set targets for economic growth, employment, or inflation that it expected the programs to achieve; nor did the Fed provide any targets for long-term interest rates. As a result, it has been difficult to determine whether the programs had the desired impact. The Fed clearly emphasized its desire to see a boost in hiring and a decline in the unemployment rate in connection with QE3; if the monthly employment reports do not improve considerably over the next several quarters, and/or if inflation measures indicate a sharp increase in prices, the Fed may be forced to reassess the program. Results would be easily assessed by whether or not the nominal economy grew toward the path targeted by the Fed within the target time frame.
Program risks The timing and dollar amount announced may be too large or too small. Finite size of the program increases uncertainty about economic impact and future policy actions. Potentially unlimited purchases of securities risk creating a large amount of money per unit of nominal GDP, creating risks of future inflation and straining the solvency of the Fed's balance sheet. Monetary policy may fail to steer nominal growth to target, eroding the Fed's credibility.

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Of the policies currently in the Fed's toolkit, QE3 most resembles the conventional policy of incremental rate adjustments we were accustomed to before the Fed was forced to peg the rate close to zero in late 2008. It goes without saying that the current federal funds rate prevails until the Fed decides otherwise. On the other hand, the announcement of a specific level of asset purchases and end date (as in previous QE attempts) creates an effect analogous to a temporary decrease in the federal funds rate. If the Fed said, "Effective today, we have lowered the federal funds rate by half a percent from 3.5% to 3.0% for nine months, after which we will increase it back to 3.5%," the effect would be to remove most of the impact of the rate cut by announcing its termination date up front, before its impact on the economy could be observed. Similarly, in announcing QE2 in November 2010, the Fed named a dollar amount ($600 billion) and an end date (June 2011), effectively binding itself to withdrawing monetary accommodation in the future before it could determine whether the accommodation was successful. This crippled its chance of having an impact. Indeed, in a speech describing the Fed's future "policy toolkit" delivered in January 2009, several weeks after dropping the federal funds rate to zero, Bernanke said:

It is important, however, that statements... be expressed in conditional fashion — that is, that they link policy expectations to the evolving economic outlook. If the public were to perceive a statement about future policy to be unconditional, then long-term rates might fail to respond in the desired fashion should the economic outlook change materially.¹

Unlike the prior rounds of quantitative easing, QE3 has avoided this problem by leaving open the ultimate size and duration of the program. It is therefore conditional on the results: if the Fed is serious about increasing employment, then households and businesses have better reason to believe the program will continue until the employment numbers improve or unless inflation appears to be getting out of hand.

The concern with NGDP targeting is that it risks the Fed's credibility by linking its actions too directly with economic results. The term "Fed speak" seems to have been coined after numerous instances of former Fed Chairman Alan Greenspan's congressional testimony in which his long-winded answers to legislators' questions left observers wondering whether they knew less following his answers than prior. While some people might find Fed speak amusing, it actually serves a specific purpose in avoiding blame for accusations of sub-optimal policy. If the Fed were to adopt a policy of NGDP targeting, the ability to escape blame would suddenly become much more difficult.

Why is this a problem rather than a solution? Given the enormous and dynamic complexity of the global economy, the Fed would likely fail to meet the proposed NGDP targets at least some of the time. Without an escape hatch — assigning blame to factors beyond its control — the Fed could see its credibility erode, which could actually worsen its ability to influence the path of nominal GDP. It is better for the Fed to avoid overly specific objectives so that it can both feign omnipotence and blame external forces when inflation and/or employment levels veer from the optimal path. While this may sound somewhat ridiculous — taking credit for success and passing blame for failure — it seems to approximate how monetary policy actually worked for more than two decades prior to 2008.

Policy Exit Strategy

With the Fed having made an open-ended commitment to purchase mortgage and government bonds until the employment level has improved significantly, it has taken a more active approach than simply promising to hold interest rates close to zero for a long time. And by not specifying a termination date or total dollar amount of purchases, it has more effectively connected the program to its intended results than past attempts at quantitative easing.

The question the Fed will need to answer at some point — perhaps sooner than it expects or desires — is how to unwind the buildup of its balance sheet in an orderly way. What frightens skeptical observers of the Fed, as well as suspicious hoarders of precious metals, is what a quick pickup in economic growth might do to inflation expectations. Banks, which have been reluctant to lend excess reserves for the past several years, and the consumers and businesses that have been reluctant to borrow might suddenly find reason to expand lending and borrowing. As banks move cash from Federal Reserve accounts into people's pockets, prices might rise — particularly on volatile goods with less flexible supply like food and energy — and inflation expectations could pick up.

The Fed says it expects to keep interest rates low at least through 2015, but if the economy picks up significant speed before then it may be forced to change its mind. In fact, the 2015 horizon may work like a gambit in which the Fed is willing to let inflation build before it pulls the plug. That gambit, along with the promise of continued asset purchases, is intended to convince people to take advantage of low rates now to make investments that will benefit by stronger economic activity and higher inflation in the future. If this gambit works, the Fed may find itself happily increasing interest rates sooner than it had planned, but perhaps later than it wants.


1 Federal Reserve Chairman Ben S. Bernanke, At the Stamp Lecture, London School of Economics, London, England, January 13, 2009, http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm.

Copyright 2012 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 6 · No. 10

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