Friday, January 14, 2011

QE2 is Working

One goal of QE2 is to raise inflation expectations.  According to the latest Cleveland Fed data on expected inflation, QE2 is doing just that: (Click on figure to enlarge.)

Though far from perfect, QE2 should be considered successful on this objective.  Raising inflation expectations is important for two complementary reasons.

First, absent any negative productivity shock, higher expected inflation indicates the Fed is also raising expectations of future total dollar spending (that is how the prices will rise).  Higher nominal spending, in turn, means the real economy should be improving too, given sticky prices and excess economic capacity.  Such an improved economic outlook will cause households and firms to increase current spending.

Second, higher expected inflation also increases the opportunity cost of holding low-yielding liquid assets like money and treasuries. This will encourage folks to adjust their portfolios away from money and treasuries to higher yielding assets.  This portfolio rebalancing will shore up stocks, real estate, and other equity-type assets. This rise in asset prices, in turn, will improve balance sheets making it easier to for household and firms to spend.  This is an important issue given the unusually large share of liquid assets being held by these sectors.

1 comment:

  1. David,
    This begs the question: If these expectations translate into real inflation, will this have the effect of lowering real interest rates of return? I think I made the argument on your QEII and Rising Yields post, that in fact the Fed was attempting to lower real rates of return. You seem to imply as much by noting that this recent news will move investors into higher yielding investment vehicles.