Wednesday, November 10, 2010

QE2 Will Not Usher in the Apocalypse

Though some folks would have you believe so.  It is far from perfect--it needs an explicit nominal target to make it truly effective--but it is a step in the right direction. Martin Wolf agrees:
The sky is falling, scream the hysterics: the Federal Reserve is pouring forth dollars in such quantities that they will soon be worthless. Nothing could be further from the truth. As in Japan, the policy known as “quantitative easing” is far more likely to prove ineffective than lethal. It is a leaky hose, not a monetary Noah’s Flood.

 The sky is not falling. But this does not mean the Fed’s policies are the best possible. It is probable that any impact on the yields on medium-term bonds will have a modest economic effect. It would be far better if the Fed could shift inflation expectations upwards, by issuing a commitment to offset a prolonged period of below-target inflation with one of above-target inflation.
In other words, Wolf believes QE2 may not pack a real economic punch in the absence of price level target.  Michael Woodford, William Dudley, Charles Evans, and  Paul Krugman agree with this assessment.  I too am a fan of level targeting (versus growth rate targeting), but would prefer to see it done by targeting some measure of aggregate spending such as final sales of domestic product or nominal GDP.  There are good reasons to favor an aggregate spending level target over a price level target, but either approach would bring the nominal economy closer to its trend and in turn spur real economic growth.  Unfortunately, though, the FOMC for some reason has chosen not to adopt a level target. This decision may amount to keeping the United Sates in economic purgatory.  So, rather than worrying about QE2 ushering in the apocalypse worry about it being much ado about nothing. 


  1. From FRED, here is a graph of nominal and real GDP along with the GDP price deflator.

    As can be seen, in the short run GDPr changes with GDPn but the price deflator is slow to change. Targeting P would tend to make GDPr less stable than targeting GDPn. The above graph I hope shows why targeting GDPn is superior to targeting P.

  2. Richard A.

    Interesting figure. It reminded me of graphs showing the nominal exchange rate and real exchange rate. There too one sees real movements are largely shaped by nominal movements. These figure are consistent with aggregate demand shocks being important drivers of the business cycle. The one caution, though, in using your graph is that there can be aggregate supply shocks that would push prices in the opposite direction. Still, it is worth a post.