Last week, the Federal Reserve announced a third round of quantitative easing, or what is referred to as QE3. This is an open-ended purchase of $40 billion a month, along with a commitment to keep rates low until “a considerable time after the economic recovery strengthens.” Many economic commentators are saying that this is a serious change in economic policy. In order to understand why this is so important to our economy now, it might be helpful to go back to an academic debate about Japan in the 1990s.
The era from the early 1980s through the financial crisis was referred to as the “Great Moderation.” It was common for economists to assume that the Federal Reserve and other central bankers could control the economy effortlessly, basically picking the unemployment rate they wanted. Prominent economists who studied macroeconomics, the field created during the Great Depression to study economic crashes, thought everyone in the discipline should pack up and go home. Robert Lucas, a renowned conservative macroeconomist, declared in a 2003 address to the American Economic Association that the "central problem of depression-prevention [has] been solved, for all practical purposes."
Central bankers usually respond to an economy slowing down or speeding up by adjusting the short-term interest rate. They’ll announce a lower interest rate when an economy slows. This encourages people to borrow and businesses to invest. If an economy is speeding up too fast, they’ll raise interest rates. They balance full employment with preventing runaway inflation, trying to keep the economy as stable as possible. During the Great Moderation, this central-bank ability seemed sufficient to handle any economic crisis.
Japan was the second-largest economy in the world in the 1990s when it had a severe recession. Its central bank, the Bank of Japan, lowered interest rates to try to offset the recession, but even lowering rates to zero wasn’t enough. Monetary policy hit a “zero-lower bound.” If interest rates were to go negative, and banks were to offer a negative interest rate, people would just hold cash instead. Since the Federal Reserve can’t offer a negative interest rate, it has no other conventional options once rates hit zero to boost the economy.
This is relevant because the United States also hit a similar zero-lower bound in the Great Recession. By 2009, with the economy in free fall, the Federal Reserve set interest rates to zero, which wasn’t enough to get us anywhere near full employment. While economic policymakers initiated a large stimulus measure through fiscal policy, most notably the American Recovery and Reinvestment Act in early 2009, it wasn’t clear what the Federal Reserve could do. Many commentators assumed that the Fed was “out of ammo.”
But the fact that traditional, conventional monetary policy of adjusting short-term rates has run its course doesn’t mean the central bank is out of options. Academics in the United States studying and debating the Japanese recession were split into two camps about what could be done in an economy that has hit the zero-lower bound.
The first camp believes that the central bank, rather than just adjusting the short-term interest rate, could always print money and purchase things to adjust the price level. A Princeton academic named Ben Bernanke was a major proponent of this approach and warned in 1999 that central bankers could find themselves stuck in a “self-induced paralysis.”
This is the main notion behind the first two rounds of quantitative easing. The Federal Reserve, now chaired by Bernanke, printed money and used it to purchase mortgage debt and longer-term government debt. Studies show that this has worked to lower rates for corporate bonds, mortgage rates, and long-term government debt.
However, there is another camp that focuses on how a central bank should act when it is up against a zero-lower bound. This group argues that if the economy starts to recover, the central bank will immediately raise interest rates. The market believes that the Federal Reserve will ultimately pull back on the expansion the moment the economy starts to pick up. This will choke off the recovery, and the expectations will act as a self-fulfilling prophecy.
In order to break these expectations, the Federal Reserve needs to commit to acting aggressively even after the recovery has started. As economist Paul Krugman put it in 1998 while discussing the situation in Japan, central banks will have to “credibly promise to be irresponsible,” by leaving interest rates lower than they’d otherwise be or by actively seeking a higher inflation rate than they’d normally tolerate, in order to allow for a full recovery. This approach is clear in a recent, popular suggestion for how to boost the United States’ economy by Chicago Federal Reserve President Charles Evans. He said that the Federal Reserve should clearly state that it would be willing to tolerate 3 percent inflation, above the normal target of 2 percent, until unemployment is down to 6 percent.
This second camp is focused on expectations and commitments—on communicating where the Federal Reserve wants to end up and what it is willing to tolerate until it gets there. The first camp is focused on the balance-sheet of the Federal Reserve—on what the Fed is buying and how it is changing the interest-rate market.
Which brings us to the Jackson Hole conference, the major event for those following Federal Reserve policy, held in early September. Another leader of the expectations camp, Columbia University macroeconomist Michael Woodford, presented a highly debated paper arguing that the Fed wasn’t taking the expectations issue seriously enough. He maintained that the positive effects of Federal Reserve actions already taken were influenced in part by the Fed’s ability to change expectations, not just by its balance-sheet effects. Woodford is one of the leading macroeconomists in the world, and his paper was a sign that other macroeconomists were going to start demanding that Bernanke do more along these lines as Fed chair.
It is best to view QE3 as an attempt to bring in both camps on how to deal with the recovery. There are two parts to QE3, one for each camp. The open-ended purchases go with the strength of those in the first camp, who want to see more action through the balance sheet. The language to keep rates low “for a considerable time after the economic recovery strengthens” directly addresses the second camp. It is a designed to tell the market that the Federal Reserve is committed to a full recovery and is willing to tolerate low rates to get there.
Many noticed, however, that there were no hard numbers in the plan, so while it is a good start, it doesn’t specify the rates or inflation that will be tolerated until the economy recovers. Some see this is as a strong feature of the policy, while others are worried. During his press conference last week, Bernanke didn’t say whether he’d tolerate a period of higher inflation while the economy recovers, which is crucial to the actual implementation of the expectations policy and whether the recovery speeds up.
The Federal Reserve has consistently held back since the recovery started. During the long summer of 2010, when the market was concerned about a double-dip, the Fed waited until November to execute QE2, which immediately crushed worries that we’d trend into deflation. Now the Federal Reserve is taking the advice of those who have been pushing for much more substantial action. Will it work? We are about to find out. Millions of people’s productive lives hang in the balance.