QE is supposed to work by reducing medium and long term interest rates. By buying loads of treasury bonds, the Fed causes the price of the bonds and other assets to rise, pushing down yields, which drives growth by stimulating spending on investment and consumption. But while this might have worked with the previous round of QE, yields on T-bonds are now at historically low levels (10-year rates are less than 3%) and there is little room for further falls.
Even if rates do fall further, they are likely to move higher again as soon as half-decent growth returns. This is because the Fed will be expected to tighten policy – by withdrawing some QE and/or raising the Fed funds rate – in order to keep inflation in check. Few potential borrowers are likely to be tempted by ultra-low rates in the present climate, knowing that these will be higher when they need to refinance. To put it another way, for QE2 to work, people must believe it won’t.
The same argument can be made about the dollar exchange rate. The dollar has weakened slightly since the Fed hinted that it might do more QE, which is helpful to the US trade balance (and unhelpful to other countries). But if rates rise again this should reverse.
Now let us consider the risks. The magnitude of the Fed’s debt purchases under the announced programme will be comparable to the budget deficit, which presents us with a different way of looking at QE2. That is, there is a new regime in which the Fed just pays the US government’s bills with new money. The Fed has removed the US government’s budget constraint.
The biggest danger, if QE2 produces no noticeable stimulus, is that the Fed will be seen as impotent and acting out of desperation. It will lose the credibility that will be vital when the need arises to fight off an attack of actual inflation.
Instead of QE2, the Fed would be better stating loudly that, with official interest rates at rock bottom and $1.7 trillion of QE already on its books, monetary stimulus is all but exhausted. This would help to focus minds on what really matters, such as the budget deficit and the continuing losses at Fannie Mae and Freddie Mac.
The US economy will improve eventually, without further help from the Fed, when the government, the states, banks, firms and households have finished deleveraging and confidence returns.
John Whittaker is an economist at Lancaster University.