Wednesday, September 21, 2011

The Fed's New Easing Scheme

Undeterred by the utter failure of QE2 in reinvigorating the U.S. economy, the Fed now announces a new "easing"-scheme. This time they will swap short-term to long-term U.S. Treasury securities. Given the fact that short-term interest rates will likely remain basically unchanged while long-term interest rates will fall, this will make monetary conditions "easier" (I.e. more inflationary).

As the lower long-term yields will increase demand for credit, this will increase money supply, inflation and nominal output. However, because the increase in inflation could be as big or bigger than the increase in nominal output, real output may not increase.


Blogger Ralph Musgrave said...

I agree that QE is a very defective measure: it is only being implemented because Congress refuses to implement any fiscal boost for the US economy. However I don’t see why QE is inflationary if there is plenty of spare capacity in the economy. And given high unemployment levels, that spare capacity exists, doesn’t it?

9:09 AM  
Blogger stefankarlsson said...

Ralph, the issue of spare capacity is irrelevant for this issue because we are talkining about ceteris paribus terms. Without any QE prices would fall, but with it it won't and prices might even rise.

That is why the U.S consumer price inflation rate despite continuing high unemployment has increased from 1.2% to 3.8% during the katest year as a result of the Fed's QE.

9:30 AM  
Blogger Ralph Musgrave said...

So what are the transmission mechanisms via which QE causes inflation? There is the fact that those who sell government debt then have an excess stock of cash, so they buy other assets. If they buy assets produced in the US, like houses, that creates employment, i.e. it partially solves the problem. If they take their money out of the US in search of better yields elsewhere (and a significant proportion have done so), that depresses the dollar which raises prices in the US. But that’s a temporary effect: not what I call inflation. If they buy commodities or commodity futures, that raises raw material prices, but this again is a temporary effect. The Bank of England’s current policy is to ignore the contribution to so called inflation of the 2008 devaluation of Sterling and the rise in raw material prices (and the recent VAT hike). That is risky policy, but it’s right, I think.

So what’s the transmission mechanism?

7:47 PM  
Blogger stefankarlsson said...

Ralph, I have already explained this. A higher money supply increases demand in the economy, something that bids up prices. Also, a weaker currency will raise import prices.

11:29 AM  

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