Last week’s decision by the Fed to extend its asset buying program known as Quantitative Easing (QE) indefinitely, or until there are clear signs of improved labour market conditions, has been greeted with considerable surprise and some consternation. Pundits will undoubtedly lament the demise of monetary discipline and warn ominously of a new era of inflation, or possibly worse —hyperinflation.
To be sure, the Fed’s decision is a bold one. But did it really have any choice? And is its decision to implement QE(n) really inconsistent with its role and responsibilities?
Recall, to begin, that the Fed has a dual mandate. Its objective function has two arguments — price stability and full employment. Now, many central bankers will argue that this mandate is redundant; that price stability is the surest way of ensuring the economy moves to full employment. The additional objective of full employment, they might say, clouds the decision-making process and creates unnecessary and unwanted uncertainty with respect to the Fed policy. I am sympathetic to this viewpoint. Under normal conditions, with well-functioning financial, labour and product markets, price stability should indeed deliver full employment over time.
But, here’s the rub: in many respects, we are not in conventional times. Last week’s decision by the Fed is an acknowledgement of that fact. It is a belated, perhaps grudging, admission that those (Paul Krugman foremost among them) who have consistently warned of the risks of a liquidity trap — in which financial markets do not necessarily intermediate savings into productive investment projects that create jobs and foster full employment — are in fact right. And, as any good intermediate macro textbook will explain, there are two ways in which policy can free an economy from the “trap.”
The first is fiscal expansion of sufficient size to drive the economy to full employment. That option is not available as a result of political gridlock and Congressional gaming. Indeed, the threat is an untimely, unwanted and unhelpful fiscal tightening that could do considerable harm to medium-term economic prospects.
The second way in which policy can help an economy escape the liquidity trap is by raising expectations of inflation. Not to put too fine a point on it, this is precisely what the Fed has decided to do by adopting QE(n). Of course, no sound central banker will say that. But, rest assured, that is the underlying objective.
The simple institution behind this rests on the fact that in the exceptional circumstances in which the Fed finds itself, cash is king. Given the prevailing, pervasive uncertainty hanging over the economy, individual households and firms are reluctant to make long-term commitments — whether it is in the form of investment in plant and equipment or, say, through the purchase of consumer durables. And if investment is below savings, firms cut back on employment, reducing incomes and validating households’ decisions to defer consumption.
In a closed economy, equilibrium is only restored when desired savings equal desired investment. This need not hold in the global economy, of course, in which differences in savings and investment are reflected in current account positions and in which foreign demand can help facilitate adjustment in an economy, like the U.S., undergoing balance sheet restructuring. Unfortunately, in the current environment, too many countries are also facing massive adjustment challenges — much if Europe is struggling with the burden of “internal devaluation” as a consequence of the adoption of the euro, Japan faces the twin challenges of demographic shifts and burgeoning public debt, China is slowing as the growth engine based on exports loses steam as others undergo adjustment; meanwhile, other countries may be targeting current account surpluses, mindful of the risks of financial crises and contagion like that which infected Asian economies a decade and a half ago.
In this environment, absent some bold action from the Fed, the outlook is one of slow growth and continuing high unemployment, as the Fed’s latest projections spell out. The problem is that, given the Knightian uncertainty that prevails, expected returns from investment are difficult to assess or simply do not compensate the option of value of waiting (holding cash). Given the prevailing low interest rate environment, a strategy of hoarding cash may not earn you anything, but neither does it result in large losses. To move individuals off that strategy, either the returns to investment have to be increased or the expected costs of hoarding cash must be raised. In the short-run, the Fed can’t do anything directly about the former (though it can in the medium- and long-term by providing clarity about its long-term objectives and promoting price stability). It can, however, work on the latter through policy announcements similar to last Thursday’s — provided they are credible. The challenge will be to raise expectations of inflation and move the economy out of the doldrums into which it has fallen, without actually allowing the inflation genie to escape the bottle.
This is the Fed’s dilemma: nobody wants higher inflation, but everyone would benefit from expectations of higher inflation. In this respect, the decision last week neatly illustrates the role of the monetary authorities in using monetary policy to coordinate the actions of millions of independent and heterogeneous households and firms. Done well, the result can support good outcomes; ill-conceived or poorly executed, such efforts can trigger bad outcomes of inflation and stagnant productivity growth.
So, did the Fed really have any choice? And is its decision to implement QE(n) really inconsistent with its role and responsibilities? In a word: “no.” The Fed’s decision is just another consequence of the New Age of Uncertainty.