QE3 & THE FED’S POLICY OPTIONS

by Cullen Roche

I had hoped that all of this QE talk was subsiding, but since the Fed has misdiagnosed this crisis incorrectly from its onset we really shouldn’t be surprised to see the wrong prescriptions continue. In his testimony this morning, Dr. Bernanke provided the various options the Fed has left in its toolkit:

“On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.”

Clearly, QE3 is on the table. What form of QE3 is still up in the air. QE3 in the form of open ended (no target size) interest rate targeting will “work” in the sense that it will control long rates. My fear is the response from the public. Open ended long bond purchases would most certainly fuel hyperinflation chatter and debt monetization fears. The cost push inflation from higher commodities would prove even more disastrous than it was during QE2. Is the Fed willing to take that risk? It certainly looks that way. A policy more similar to QE2 (not open ended, but size targeting) should be expected to have similar effects by squeezing households further as commodity price speculation strangles the economy.

The other two policy responses appear relatively weak. Cutting interest on reserves is unlikely to help much if at all because of the obvious limitations. More explicit guidance might provide some clarity on the future, but it’s not world changing. It’s more confidence fairy policy than anything else. These are marginally helpful, but in a $15T economy they’re not moving the needle much.

I still think the Fed’s rational response should be to acknowledge that we are in a household debt crisis and discuss the various ways in which they’ve attempted to help while also discussing the various reasons why history proves monetary policy to be particularly ineffective during this sort of unique environment. The Fed should emphasize the need for greater fiscal policy, emphasize that the US government is not bankrupt and serve as a guide to recovery rather than attempting to fix a problem you are not equipped to deal with. That’s clearly not the path we are taking though.

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