The goal of quantitative easing at the zero lower bound isn’t to lower nominal treasury yields (though that’s not a surprising immediate effect) but to lower expected real yields by raising inflation expectations.
As St Louis Fed president James Bullard explained last Thursday, so far so good. Since Bernanke gave his Jackson Hole speech telegraphing further QE, real interest rates are lower, inflation expectations and US equities are higher, and the dollar has broadly depreciated against other currencies.
Or if you want to look at it another way, at the very least the expected probability of deflation is lower than it was earlier this year — as you can see in this new chart from Macroblog:
There was a lot of commentary in the aftermath of the FOMC’s decision arguing that asset prices had begun moving in the wrong direction, but it’s just as likely that this reversal was simply a correction to an overplayed trade.
The latest batch of stories explaining the recent rise in the 10-year above 3 per cent only seem to underscore the point — they attribute the move to recent economic indicators that have turned out better than expected (except, of course, on housing and unemployment).
What are the right criticisms? One is that no matter what the Fed says, nobody has any idea what unwinding a Fed balance sheet nearly triple its normal size (and will keep growing) is going to look like. Another is that asset markets are so distorted that price signals are difficult to interpret, and investors will look more towards future Fed and government moves in making investment decisions than anything to to with underlying fundamentals.
Still another is that lax credit conditions might be postponing the inevitable for weaker companies by making it so easy to refinance. Add to that continuing concerns over currency wars. And although we think unhinging inflation expectations is unlikely, it’s something reasonable to worry about.
It’s hard to say if the impact on the markets will have the desired impact on the real economy. By raising expectations of future inflation and inflating asset prices, QE2 is supposed to entice companies and individuals to spend more money. But companies already have plenty of cash, they’re just not spending it — instead they’re doing things like buying back shares, raising dividends, and considering more acquisitions. But they haven’t (yet) been spending more on capital and labour.
For all of these reasons, we continue to embrace the cowardly agnostic position on QE2.
But there’s one final point. Similar to Tarp, the true cost of the Fed’s recent activity can’t be judged on dollars and cents alone. Not immediately, anyway.
As we’ve noted previously, QE2 has inevitably made the Fed an increasingly political body. In addition to the many statements by regional Fed presidents, Bernanke himself is now offering his opinions on fiscal stimulus, deficits, the tax code, and other things — while the president publicly defends the central bank’s policy before an international summit and the treasury secretary defends the Fed chairman from his predecessor.
The fallout from the increased politicization of the Fed is highlighted in this long Bloomberg Businessweek article about the (perhaps uncomfortably) close relationship between Bernanke and Tim Geithner:
On Nov. 15 a group of 23 mostly Republican economists, money managers, and former government officials sent an open letter to Bernanke arguing that the central bank’s bond purchases “risk currency debasement.” Two days after that the four Republican leaders in the House and Senate—John Boehner of Ohio, Eric Cantor of Virginia, Mitch McConnell of Kentucky, and Jon Kyl of Arizona—wrote to Bernanke to express their “deep concerns” over bond purchases that could lead to “hard-to-control, long-term inflation and potentially generate artificial asset bubbles.”
Ever since, Bernanke and Geithner have found themselves pitted against the Republicans and the Tea Party in a battle that could help determine the fate of the economy, Obama’s Presidency, and the Federal Reserve itself. Some of their Republican opponents, such as Pence and Tennessee Senator Bob Corker, want to strip the Fed of its mandate to pursue full employment and focus on price stability alone, which would make it harder to justify future rounds of quantitative easing. The most radical antagonists want to go further. Senator Rand Paul (R-Ky.) and his father, Rep. Ron Paul (R-Tex.), argue for doing away with the central bank altogether. Forty-one percent of Republicans and 55 percent of Tea Party supporters believe the Fed should be abolished or radically overhauled, according to a Bloomberg National Poll conducted Oct. 7-10. …
Yet some Republicans acknowledge that the latest attacks are about politics as well as policy. “There is a real perception among Republicans that for all intents and purposes, Bernanke is a member of the Administration,” says Mark A. Calabria, a former aide to Alabama Senator Richard C. Shelby, the ranking Republican on the Senate Banking Committee. It doesn’t seem to matter that Bernanke, a registered Republican, was nominated in 2005 by President George W. Bush, or that politics used to stop at the Fed’s front door. “The Fed needs freedom to act and act quickly,” says Martin Neil Baily, who served as chairman of the Council of Economic Advisers in the Clinton Administration and is now at the Brookings Institution in Washington. “Those are decisions that need to be made outside politics.”
We don’t want to overstate the threat to central bank independence here, and much of the criticism from Republicans is just silly. Plus, as the article goes on to mention, this kind of political assault has been seen before, the last time when Paul Volcker raised interest rates to 20 per cent and plunged the economy into recession in his successful bid to slay inflation. The Fed emerged from that earlier period intact, and until the recent crisis had become an even more revered, powerful entity under Alan Greenspan (somewhat regrettably, we might add).
More worrying is that last bit from the excerpt, in bold. We’re just speculating, but how the political situation for the Fed plays out could affect not just how it acts in the next year or two (while the recovery is still fragile) but also the dynamic of what it has to consider in future crises.
Bernanke is trying to strike a difficult balance — hitting back at critics and spurring Congress to do more on the economy, while also maintaining that his actions and words are consistent with his mandate, and haven’t trespassed beyond the boundaries of his responsibilities. And it could be that it all amounts to nothing. If the economic recovery accelerates, for instance, the pressure will surely weaken.
But the political heat underscores the uneasy terrain on which Bernanke now finds himself. When he comments on matters outside the traditional scope of the central bank chairman, obviously he has judged that the risks of staying out of the fray outweigh the risks of playing the game. And he may be right — but a risky game it is, and we still don’t know how it ends.
Maybe it’s working, and maybe it isn’t – FT Alphaville
FOMC composition and the future of monetary policy – FT Alphaville