The Goldilocks Number?

The world is agog over the sailing of QE2, the U.S. Federal Reserve’s second big round of quantitative easing. Yesterday, the Fed announced that it would buy $600 billion in government bonds over the next eight months.

There has been a wide range of reactions:

• This was the right and sensible thing to do (Fed Chairman Ben Bernanke).
• Just what we expected (markets).
• Not enough! We need several times more. (Goldman Sachs)
• Too much! Watch out for inflation! (Kansas City Fed President Thomas Hoenig)
• You’re going to drive up the euro! (French Finance Minister Christine Lagarde)
• You’re devaluing the dollar! (China)
• What’s quantitative easing and why does it matter?

For the latter segment of the population, here’s a quick overview. There are traditionally a few ways in which a government can spur or slow the overall economy. With fiscal policy, a government can add or subtract from the total demand for goods and services. This sounds good in theory, is a big part of John Maynard Keynes’ claim to fame, and was the intellectual underpinning of recent stimulus efforts. It’s harder to do in practice. It actually fell out of favor in macroeconomics in the 1970s because the underlying theory said we should not see high inflation coexist with high unemployment, and yet we did (stagflation). That led macroeconomists off into explorations of how individuals base their decisions on sophisticated expectations of the future, not simple-minded extensions of the past. In those rational expectations models, fiscal measures may not be nearly so effective as in straight Keynesian models.

Let me defer the topic of the day — monetary policy — for one paragraph and note that the government toolkit also includes setting the business climate. Taxes can be high or low; regulations can be burdensome or light; policies can be predictable or frenzied. Macroeconomics is so named because it focuses on the way aggregate economic indicators move — unemployment, inflation, consumption, etc. But aggregate production, GDP, is made up of the output of many small, medium, and large businesses and each faces its own incentives to expand or contract production. The business climate arguments suggest that deterrents at the micro level can have important effects at the macro level. This is the reasoning behind presumptive incoming House Speaker John Boehner’s (R-OH) criticism of the uncertainty introduced by Obama administration economic policies.

And now to quantitative easing, which is really just Xtreme Monetary Policy. In standard monetary policy, the Fed moves interest rates up and down. Higher rates make it expensive to borrow for business projects or consumer loans and thus tend to slow economic activity. Lower rates do the reverse. Normally, one doesn’t have to delve into the weeds and mention that the Fed targets very short term interest rates (think a few months or less). The assumption is that longer rates will follow along.

But we’re deep in the weeds with QE2. The problem is that the Fed has held short term rates near zero for a while now, with unsatisfactory results. They had to either give up or get creative. They chose the latter. While short rates have been stuck near zero, long rates have been higher, reflecting expectations that rates will eventually rise. Right now the 10-year government bond is trading at a yield (interest rate) of roughly 2.5 percent. The Fed can drive these longer rates down by buying those bonds directly (higher bond prices mean lower yields). And that’s just what the Fed announced it would do yesterday, to the tune of $75 billion a month. For all practical purposes, this can be thought of as printing money.

So what’s not to like? A first objection is that the Fed is risking inflation. There is a long history of countries firing up the currency printing presses and suffering as prices spiral out of control. At the moment, though, the Fed is worried about the pernicious potential of deflation (falling prices). Somewhere between falling prices and soaring prices should lie stable prices, which is the Fed’s true desire. That ideal would be easy to attain if the economy responded instantly to monetary policy changes, but it doesn’t; the effects only kick in with a lag (perhaps 18 months). In normal times, the Fed can back out of its stimulative policies by raising interest rates. It’s tougher to do that with a big unorthodox portfolio of bonds.

The second objection is that the Fed is disregarding the rest of the world and debasing the dollar. The Fed doesn’t directly control the value of the dollar, but in general currencies respond to interest rates and expected inflation. Low interest rates and higher expected inflation will generally push a currency down against its peers. No U.S. official will claim this is the intent of domestic economic policy, but it is a happy coincidence that a weaker dollar makes U.S. goods relatively cheap for foreign buyers and makes imports relatively expensive.

The broad recognition of this happy coincidence leads to concerns about competitive devaluations, angry trading partners, and a protectionist response. Competitive devaluations would not necessarily be so harmful — it could look like a global monetary stimulus — but protectionist responses could do lasting damage.

This is the motivation for attempts to address global imbalances in a coordinated way. As I wrote earlier this week, that hasn’t been going so well. It would certainly be possible to stimulate the U.S. economy through a burst of demand from abroad. In the absence of such an external boost, though, Ben Bernanke’s QE2 seems the best option available.