Tuesday, June 21, 2011

The Fed's impotence

Back when the Fed was debating whether to embark on a second round of quantitative easing (QE2), I was one of many who argued that QE2 would not have the intended effect of stimulating the economy and/or staving off deflation.  My arguments were deceptively simple: (1) the weakness in the economy had nothing to do with monetary policy not being loose enough and (2) deflationary risk was very small.  In short, QE2 was a solution in search of a problem.  These simple arguments did not win the day, however, as the Fed came up with some inventive theory-twisting and data-torturing to justify further monetary loosening.

John Cochrane outlines how the doubters (Dan Thornton of the St. Louis Fed was especially prescient) have turned out to be right:  "All QE2 does is to slightly restructure the maturity of U.S. government debt in private hands," without lowering interest rates (hat tip: Greg Mankiw).  That's not to say that large-scale quantitative easing is never appropriate.  After all, strong arguments can be made that QE1,which was launched in March 2009, was vital in preventing an even worse economic meltdown. In a nice roundup by Dave Nicklaus of the St. Louis Post-Dispatch, Rick Hafer points out that QE1 and QE2 were very different animals: "QE1 bought mortgage-backed securities at a time when the mortgage market was deeply troubled, while QE2 bought only U.S. Treasury securities." 

From my standpoint, QE2 was implemented only because the Fed was too arrogant to accept its own impotence.  Although current Fed decision makers don't appear to have been humbled by this episode, let's hope that future ones have learned something about the limits to their influence on the economy.