The Catch-22 of Quantitative Easing
It’s no secret that markets have become addicted to quantitative easing. The purchase program currently held by the U.S. Federal Reserve has defined the post-crisis recovery, and Chairman Ben Bernanke’s recent testimony before Congress demonstrated that even nebulous speculation about the future of this program has the ability to send global markets tumbling lower.
Quantitative easing has four primary effects on the economy: higher inflation expectations, currency depreciation, higher equity valuations, and lower real interest rates. QE is similar to normal monetary policy in that it puts downward pressure on nominal and real interest rates. However, current policy has only been somewhat successful when measured against these criteria. Equity valuations are certainly higher and interest rates have certainly been lowered. The position of the dollar relative to major foreign currencies has been a bit chaotic, but this is as much due to the actions of the Bank of Japan and the European Central Bank as anything else.
At a glance, where the policy has failed is in its ability to maintain the Fed’s target inflation rate of 2.0 percent. Remember that the U.S. Fed has a dual mandate: to pursue maximum employment and price stability, and that it explicitly set forward guidance in relation to a 2.5 percent inflation threshold and 6.5 percent unemployment target as the minimum criteria for a policy rate move.
The problem, as any given economist would be quick to point out, is that inflation is low. As Bernanke put it a few weeks ago, “if anything, [it] is a little bit too low.”
The reason why low inflation is such a problem right now is that — combined with improving labor market indicators — it sends a mixed signal to the Fed. With forward guidance set as a function of employment and inflation, improving employment suggests that easing can be curbed. However, low inflation suggests that there is room to keep going.
Speaking on CNBC’s “Squawk Box,” St. Louis Fed President James Bullard said, “I don’t think we have a good story for why [inflation] is so low.” Bullard was specifically indicating the core inflation measure, which strips out typically volatile food and energy prices. Headline inflation rates — which include food and energy — have faced downward pressure in the United States as energy prices fall.
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