Friday, May 6, 2011

No Matter How You Cut It, QE Remains Wrong

The Federal Reserve is fully committed to a "fire at will" monetary experiment called Quantitative Easing (QE). It basically means that the central bank allows affiliated banks to exchange all kinds of "colorful" pieces of paper for another "colorful" piece of paper called dollar. Note that only banks are allowed to participate: you're not allowed to bring any of your own colorful pieces of paper (such as your house title or your high school diploma) to the Fed and exchange it for dollars.

The interesting thing about QE is that, no matter how you try to explain its effects on the economy, you get to the conclusion that it's wrong. If you're one of those economists that think that printing high-powered money as if there's no future has avoided an American output collapse without creating inflationary pressures, then you need to explain the fast rate of depreciation of the dollar and the increasing price of commodities while unemployment remains high, investment low and growth anemic. If you say that it's not the dollar that is weakening, that it is the price of commodities and other currencies that are frothing, then it doesn't really matter: the monetary policy is wrong anyway for creating such frothing (no need to get into the merit of what a bubble really is as long as it is QE that is causing it).

I'm for a much simpler explanation for the monetary policy problems that we're experiencing. It's a combination of two typical problems in central banking: (a) central banks historically overestimate negative output gaps (remember the 70s!) and (b) the inflationary effects of monetary expansions can take a very long time to happen, particularly after a long period of stability and falling but yet high central bank credibility. In other words, we should never underestimate the power of denial when it comes to potential output and NAIRU calculations. On the other hand, central bank credibility has only gone down since the beginning of this crisis.

On the subject, The Economist's Buttonwood asks the gazillion dollar question on frothing asset and commodity prices:
The equity market sell-off could be ascribed to the same weak growth numbers that sparked the commodity decline. Nevertheless, it does draw attention to the contradictions inherent in this long bull-run. Central banks are holding interest rates low (and using QE) because the economy is weak. But if the economy is weak, why have equity and commodity prices done so well?

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