Sunday, September 23, 2012

Open ended QE

The Federal Reserve announced open-ended QE last week, which is unprecedented for any central bank and its implications (positive or negative effects) are not very well understood yet.  Here is the Fed's press release.
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.
The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.
In addition to the ongoing Operation Twist (extending duration of the Fed's portfolio), the Fed has also decided to purchase agency-backed MBS for the tune of $40 billion a month, until the labor market improves. They have not clearly specified the target they are looking at, which is worrisome.

In any event, this press release and the decision making by the Fed is seen as a victory for the Market Monetarists such as David Beckworth, Scott Sumner and a few others. These people have been vocal about the need for the Fed to target NGDP (nominal GDP) and therefore set market expectations that it will do whatever it takes to restore NGDP to trend growth. This, they believe will alter the market psychology (because the Fed is a monetary super power) and therefore boost spending, hiring, wages and the road towards recovery.

But the whole thesis is hinged on one simple assumption: aggregate demand short fall. Is that the real reason behind the economic malaise? What is the root cause if it is not aggregate demand? Is aggregate demand merely a symptom of a system that has taken on too much private debt? Is the system too centralized and therefore prone to fragility? Consider this post by John Aziz.
My theory is this: our depression is not a problem of insufficient demand. It is systemic; most prominently and immediately financial fragility, financial zombification, moral hazard, and excessive private debt, alongside a huge number of other long-term systemic problems.
What if the Fed and the market monetarists are completely wrong? What if all central banks engage in a competitive devaluation strategy and these currency wars precipitate into trade or real wars? Here is Ed Haddas from Reuters:
It is a dangerous way to conduct monetary policy. A large trade surplus may have helped create jobs in China, but the accumulated funds helped finance the asset bubbles which eventually popped, leading to the current global malaise. The Fed’s previous rounds of quantitative easing just might have helped the American economy, but they almost certainly pushed up commodity prices, which stimulated economic and political tension in many poor countries. They also spawned ill will among the central bankers who were forced to deal with collateral damage from the U.S. war against domestic financial disorders.

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