QE2

Monetary policy

Who's disappointed in QE2?

Apr 25th 2011, 1:35 by R.A. | WASHINGTON

BINYAMIN APPELBAUM has written a story that's gotten a lot of attention today, headlined "Stimulus by Fed is disappointing, economists say". I have to say, I find the piece itself a bit disappointing, for two reasons. First, it provides almost no sense of against which benchmarks QE2 has disappointed; Mr Appelbaum names an estimated impact of QE2 purchases on interest rates, but he doesn't make any explicit macroeconomic comparison using numbers from before the Fed began talking about QE2 and from now. And second, the piece does illustrate the way in which the Fed left itself open to this kind of criticism and potentially reduced its ability to respond appropriately to economic conditions.

Take the first point first. Mr Appelbaum writes:

The Federal Reserve’s experimental effort to spur a recovery by purchasing vast quantities of federal debt has pumped up the stock market, reduced the cost of American exports and allowed companies to borrow money at lower interest rates.

But most Americans are not feeling the difference, in part because those benefits have been surprisingly small. The latest estimates from economists, in fact, suggest that the pace of recovery from the global financial crisis has flagged since November, when the Fed started buying $600 billion in Treasury securities to push private dollars into investments that create jobs...

Mr. Bernanke and his supporters say that the purchases have improved economic conditions, all but erasing fears of deflation, a pattern of falling prices that can delay purchases and stall growth. Inflation, which is beneficial in moderation, has climbed closer to healthy levels since the Fed started buying bonds.

“These actions had the expected effects on markets and are thereby providing significant support to job creation and the economy,” Mr. Bernanke said in a February speech, an argument he has repeated frequently.

But growth remains slow, jobs remain scarce, and with the debt purchases scheduled to end in June, the Fed must now decide what comes next.

So, a crucial question is: what did we expect QE2 to accomplish? Early in the third quarter of last year, immediately prior to Ben Bernanke's strong hint that additional asset purchases would be forthcoming, expectations for growth and inflation were falling, the probability of a double-dip recession was rising, confidence was lagging, and private employers were creating around 100,000 jobs per month. This deterioration is why the Fed acted. Did the Fed hope to influence interest rates? Sure, but that's just one of the means available to the Fed as it pursues its desired ends: a stable rate of inflation supportive of economic growth.

So what happened after Mr Bernanke made it clear to markets that the Fed would act again? Growth accelerated, from a 1.7% annualised pace in the second quarter to 2.6% in the third quarter and 3.1% in the fourth quarter. Inflation expectations ceased falling and began rising back to normal levels. Confidence rose. And the pace of hiring improved meaningfully. In both February and March, private firms added over 200,000 jobs. Since the Fed's policy began, the unemployment rate has fallen a full percentage point.

Now, is growth estimated to be lower in the first quarter than it was in the fourth? Yes, yes it is. Is this because the Fed's policy failed to reverse falling expectations? No, no it isn't! Bad winter weather in the January constrained hiring and has been estimated to have trimmed first quarter output by half a percentage point. Rising oil prices—partially a product of growth but exacerbated by Middle Eastern unrest—likely cut another half a percentage point off of GDP growth. Global markets experienced a serious setback during the second half of March associated with the uncertainty generated by the seismic disaster in Japan, and the push toward austerity in America has proceeded unexpectedly quickly over the past few months. Growth in the first quarter is disappointing, it's true. Without QE2 it would be more disappointing still, and very probably negative.

So has QE2 accomplished what most reasonable onlookers expected? I think it's fair to say that it has, and I think it's clear, in the light of these realised expectations, that QE2 was a very good thing to have. Asset purchases were designed to improve economic conditions relative to what would have otherwise prevailed. And Mr Appelbaum doesn't come close to arguing that the policy failed on this count.

But the Fed set itself up for this kind of criticism, and for harsher words still from worse informed individuals than Mr Appelbaum. The Fed chose a number—$600 billion—when it announced a new round of asset purchases. The choice of a number conveyed the impression that the Fed new exactly what was needed. Had it known for sure that it needed less or more, it would presumably have opted for less or more. Perhaps it couldn't have been sure what was needed. In that case, it would have been helpful to lay out a policy target and declare that they'd act until they either hit the target or concluded that hitting the target was impossible. The target, presumably, would be a rate of inflation or a price level or a rate of nominal output growth or a level of nominal output.

Unfortunately, the Fed didn't set a policy target. Instead it opted for the $600 billion figure, thereby inviting critics to judge the Fed on whether $600 billion was, in fact, the right action to take. Since the Fed didn't establish what, exactly, it was hoping to accomplish with its $600 billion, in terms of an observable policy target, it left the door open for people to assume that it was doing what it viewed as necessary to make the economy work again. And if the economy isn't quite working again, well, observers can be forgiven for experiencing some scepticism of the value of expansionary monetary policy.

But that's problematic for the Fed. It will be much easier for people, inside the Federal Open Market Committee and out, to argue that the benefits to additional expansion are smaller than believed and since the economy has improved meaningfully from last summer, there's less pressure to act in the first place. The Fed chose a direction rather than a destination, and when its action left it short of the destination, it opened the door to criticism that the direction was wrong, when in fact it may simply have traveled an insufficient distance (perhaps thanks to unexpected headwinds). If you target a destination, you don't run into that problem.

The Fed's stimulus has not disappointed, in my view. The Fed itself, well, that's a different story.

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