Would QE2 help?

As Bernanke gives an important speech in Boston Fed today, there are expectations that he will be clearer on Fed’s upcoming monetary framework. People have already factored in quantitative Easing – 2.0 (QE2) and questions asked are not whether but how much would it be?

Daniel L. Thornton of St Louis Fed reviews the various thoughts on QE2 in this short note. He says it will not be much useful this time.

First, we still do not know whether QE 1.0 worked. As per this research, QE 1 was about 1.75 tn dollars and led to decline in Treasury yields by 38 to 82 bps.  So people feel if QE2 is worth USD 1 tn it should lead to an effect of 22 to 48 bps.

Now there are a couple of issues with this. One, this time financial  markets are working fine and economists not sure whether any purchases would work this time. Two, as per Hamilton, the yields have already lowered by 60 bps in wake of expectations and Fed does not need to do anything. It is already more than the probable 22-48 bps. Three, just like banks did in QE1, hoarded on to the reserves, they can do the same now as well.

Second, even if QE led to lower interest rates, such a small decline will hardly affect output and employment:

Even if QE2 did affect interest rates, many believe that the effect on output or employment would be small. For example, Charles Plosser, president of the Philadelphia Fed and a nonvoting member of the FOMC, recently suggested that “[I]t is difficult…to see how additional asset purchases by the Fed, even if they move interest rates on long-term bonds down by 10 or 20 basis points, will have much impact on the near-term outlook for employment. 

One reason is that even in normal times, investment spending is not particularly responsive to changes in interest rates: Investment spending depends more on the economic outlook. Consequently, some analysts  believe that reducing interest rates modestly from their already historically low levels is unlikely to stimulate aggregate demand: Little effect on aggregate demand implies a corresponding small effect on output and, hence, employment.

Furthermore, even if QE2 significantly affected output, its effect on employment would likely be somewhat smaller
than usual for two reasons. First, at least some of the current unemployment is likely to be structural (i.e., there is a mismatch between the skills of the unemployed and the skill needs of employers). There is little monetary policy can
do about structural unemployment. Second, employment growth has been particularly sluggish in the previous two
recessions, suggesting that post-recession employment dynamics differ greatly from those before the late 1980s,
which suggests that the labor market has fundamentally changed.

Extending this to inflation expectations, not much can be done. As output is much lower than potential, inflation exp will remain subdued. Unless Fed announced an inflation target, there is little reason why expectations should rise.

Finally in case QE fails, it will be more trouble:

Finally, it should be noted that QE2 could have adverse effects. For example, Plosser has expressed concern that if the FOMC undertakes QE2 and the actions are ineffective, it could damage the “Fed’s credibility and possibly erode the effectiveness of our future actions to ensure price stability.” He suggests that QE2 might also raise concerns that “the Fed is seeking to monetize the deficit [which] might make it more difficult to return to normal policy” in the future.

 Great coverage of issues on QE2 by Thornton. Makes some sense as well.

Though, with such high expectations Fed might just have to go on with QE. Otherwise markets in US are going to be disappointed. It is being termed as Bernanke Put by market participants. But yes if Bernanke chooses not to, policymakers in emerging economies might take a breather. Surge in Capital inflows is becoming a major concern for India and others.

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