John Williams of the SF Fed says QE is already working.  Mr. Williams claims that recent market action proves that QE is already having positive impacts.  Of course, bond yields are now higher than they were before the Jackson Hole speech, equities have risen substantially (but Robert Shiller has debunked the equity market wealth effect), and commodity prices have surged and therefore increased input costs.  So, if, by “working” Mr. Williams means that QE is making the economic outlook more unstable then he is certainly correct.  Although I disagree with his conclusion that QE is “working” the speech is certainly worth a read as it provides a nice 30,000 foot view of what is happening to the US economy:

First, the crash of housing and the stock market’s retreat destroyed trillions of dollars of household wealth, as I noted.  The loss of wealth causes people to save more in order to rebuild their retirement and college fund nest eggs.  The first figure shows the ratio of net wealth to disposable personal income.  At the peak of the housing bubble, it reached nearly 6.4.  We’re now back to a historically typical value for this ratio of about 4¾.  According to standard estimates of the so-called wealth effect, which is the tendency of accumulated assets to encourage consumption, the decline in net worth since the start of the recession will reduce consumer spending by about $430 billion, or 4½ percent, relative to its pre-recession level.

Figure 2: Household Debt Hangover
Figure 2: Household Debt Hangover

Second, adding insult to injury, consumer debt reached unsustainable levels during the bubble years.  The second figure shows the ratio of household debt to disposable personal income.  You can see a clear upward trend in this ratio over the second half of the 20th century.  But, what is even more striking is the explosion during the housing boom, when households piled on debt, bringing the debt-to-income ratio to an all-time high of 1.3.  Well, the party is over and we are in the midst of a long hangover.  Families are paring back spending in an effort to get out from under this mountain of debt.2

Third, the easy credit of a few years ago has given way to an environment in which it’s tougher to get a revolving credit line, a mortgage, or other loans.  Certainly it’s hard to use home equity to fund consumption when the value of your home is flat or declining.  The ATM called home just won’t give out cash any more.  Fourth, slow income growth is also limiting the ability of households to spend more.

Finally, high unemployment, stagnant wages, and a fragile economy have sapped consumer confidence and made people cautious about spending.  If you’re uncertain whether you’ll have a job next month, you think twice about buying a house or car.

Put it all together and you have a recipe for consumer spending growth significantly below what is typically seen in recoveries.  Growth in consumer spending has been running at about trend for the past few quarters.  I don’t see anything on the horizon that will dramatically change this picture in the near term.  And the housing market is likely to remain in the doldrums for even longer.

I’d like to turn now to inflation, or, I should say, the lack of inflation.  The measure of inflation we follow most closely is the core personal consumption expenditures price index.  These prices have been rising at a 0.9 percent rate so far this year.  This is the lowest nine-month inflation rate recorded in the over 50 years that this statistic has been compiled.  Our forecast is that inflation will come in about 1 percent for the year as a whole and stay at that rate next year.  That’s about 1½ percentage points below where it was at the start of the recession and well below the level of around 2 percent that most Fed policymakers have said is consistent with stable prices.

It’s hardly a surprise that inflation is so tame.  There is a great deal of slack in the economy and workers are in no position to demand sizable wage increases.  And both consumers and businesses have learned to wait for bargains before making purchases.  Our retail contacts speak of a brutal sales environment in which heavy discounting has become the norm and holiday sales start around Halloween.

Figure 3: Rising Risk of Deflation
Figure 3: Rising Risk of Deflation

To me, the danger is that weak demand and excess productive capacity could cause inflation to fall further, taking us perilously close to deflation. That’s what happened to Japan in the 1990s, a painful period for them characterized by slowly sinking prices and alternate bouts of slow growth and recession.  I want to show you a sobering chart that overlays the recent U.S. core consumer price index inflation trend line with that from Japan’s lost decade.  Although there are many differences between the economies of the two countries, there are some important parallels between Japan’s situation then and that of the United States today.  Japan was also mired in an extended period of subpar growth.  Like in the U.S.A., Japanese consumers and businesses were reluctant to spend.

Few of us have experienced an extended period of deflation, but it’s not pretty.  The New York Times recently ran an article about how ordinary Japanese citizens coped with deflation.  It described how people stopped buying homes, cars, and other discretionary items because they could be had for a cheaper price in the future.  Businesses postponed investments because the returns from holding cash were better than what they could reliably expect to earn by expanding operations.  The article conveyed a pall of gloom that hung over the Japanese economy, sapping confidence and further fueling a deflationary hesitance to spend.

The good news is that I firmly believe that we can avoid a pernicious bout of deflation here.  I described the similarities of our situation with Japan’s, but there are also some critical differences, which makes the chances of prolonged U.S. deflation quite low.  One of the most important of these concerns financial conditions.  When Japan’s banks found themselves with enormous portfolios of bad real estate and commercial loans, regulators allowed the banks to kick the can down the road.  So-called zombie banks were incapable of lending on the scale needed to revive Japan’s economy.  By contrast, U.S. policymakers shut down failing institutions and forced remaining banks to recapitalize.  While lending hasn’t fully recovered, there’s no question that U.S. financial institutions are far healthier today than Japan’s were in the 1990s.

In addition, following the Fed’s successful reduction of inflation starting in 1979, research shows that Americans have come to expect that inflation will be low, but positive.  In economics jargon, inflation expectations are well anchored.  That means that people expect the Fed to take action to keep inflation low and stable, and do everything in its power to prevent deflation.  The anchoring of expectations helps us avoid the onset of a deflationary mindset that could create conditions for a downward spiral in wages and prices that would be highly damaging to the economy.

Finally, and perhaps most importantly, we’re also different from Japan in monetary policy.  One lesson from Japan’s experience is the need to act aggressively before deflation becomes firmly entrenched.  In contrast with Japan, the Fed has adopted proactive measures to head off a deflationary spiral before it can take root.  This brings me to current Fed policy and, in particular, the recently announced program to purchase Treasury securities.

By way of background, it’s important to understand that by law Congress has charged the Fed with two objectives: maximum employment and price stability.  Currently, the Fed is falling short on both counts.  Unemployment obviously is unacceptably high.  And, as I’ve explained, inflation is somewhat below the level that is consistent over the long run with stable prices.  In other words, the Fed would like to kick the recovery into a higher gear and nudge inflation up a bit, avoiding further disinflation.

The Fed’s traditional policy tool is the federal funds rate, which is the overnight interest rate banks charge each other for loans.  We’ve had our federal funds target set near zero for almost two years now and obviously that’s as low as it can go.  So, to provide additional stimulus to the economy, we’ve used unconventional policy tools, most notably beginning nearly two years ago a program to purchase up to $1.75 trillion in Treasury securities and agency mortgage-backed securities and debt.  This program has helped push down mortgage and other long-term interest rates, thereby supporting the housing market and the economy overall at a time when it desperately needed a boost. The Fed’s latest program involves purchases of a further $600 billion of longer-term Treasury securities, which will be carried out at a pace of about $75 billion per month.  The idea is the same as before–to push medium and longer-term interest rates down further, giving added support to economic activity.  So far, the responses in financial markets show that this program is working.

Like all monetary policy decisions, there are risks associated with this action.  I would like to talk about the concern that we may see a return of high inflation because of the large amount of monetary stimulus.  Although I take this concern very seriously, I see the risk of high inflation as remote.  First, there are no signs of the kind of overheated economic activity that triggers inflation.  Indeed, all measures of slack I know of show the economy is running well below its potential and inflation is trending down, not up.  Second, the inflation expectations of households, investors, and economists point to low, not high, inflation in years to come.  In the 1970s, the last time we saw runaway inflation, inflation expectations had clearly become unmoored.  Third, the Federal Reserve has the means and, most importantly, the will to reduce monetary stimulus when appropriate.  As it has for the past three decades, and as it affirmed in the November 3 policy statement, it will monitor the economy carefully and adjust the stance of monetary policy to preserve price stability.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

More Posts - Website

Follow Me:

  • Greater Fool

    Two months of equity gains (minus the past week) is a little bit premature to be making calls on whether or not QE2 is “working”.

  • boatman

    i’m with shiller on this one cullen.

  • http://www.pragcap.com TPC

    Being with Shiller is generally a pretty good rule of thumb….

  • MG

    Irrespective of whether QE2 is working or not, his macroeconomic outlook appears very similar to that of the pragmatic capitalist.

  • Anonymouse

    If QE2 is working, why does the Fed’s report out today say the economy is still slowing:

    “The pace of recovery in output and employment in the U.S. economy looks a little slower now than it did three months ago, according to 43 forecasters surveyed by the Federal Reserve Bank of Philadelphia.”


    TPC – Great great question…..The Fed is essentially admitting that things are worse since rumors of QE started….

  • Mediocritas


    I won’t repeat what I’ve said in the past regarding QE2 but I’ve just thought of something new. I recall that following the 2008 collapse, Australia experimented with a “helicopter drop”. It was a $900 credit paid to all citizens that had filed a tax return in the previous year. The process was quite similar to QE2, the government selling paper to fund the payout with the RBA on the other end of it (no doubt). The effect was positive for the economy.

    So I wonder if we might see the same in the USA? I was expecting such a thing in the future (for QE3) as the Fed grew a brain and realized that boosting government spending and the money supply (temporarily) through funding Treasury paper is not as productive for the economy as boosting spending in the private sector (higher resolution in the latter case). Government wages are already rising too high, QE2 is generally not popular, the Democrats are losing support, the private sector is collapsing: all of these factors suggest that QE2 may indeed end up being a copy of the Australian experiment.

    Just a thought. It’s one that Obama has to be considering as a way to get that QE2 cash into the economy. Still, my basic opinion on all of this is that QE2 is a stealth bailout for the states and a personal cash drop would be in QE3.

    TPC – Tax credits are fiscal as are all helicopter drops. This is not in the Fed’s power and would have to be issued by Congress and tsy. Won’t happen bc the govt thinks we’re bankrupt….

  • Bruce

    I think Bush did this 2 or 3 times while he was president, below a certain income level. It was $250 or something. And Obama I think gave $250 last year to social security recipients.

  • Mediocritas

    One reason is might happen is due to the political effect. Tax cuts are perceived negatively as most people view them as a handout to the rich over the poor, but a flat tax credit is seen as “fair”. I remember seeing Australians lighting up the social networking sites (Twitter, FaceBook etc) when it happened. The program was wildly popular and the government’s popularity soared.

    So it might happen closer to the next major election if the Democrats continue to lose popularity.

  • goodfriend

    quote “So-called zombie banks were incapable of lending on the scale needed to revive Japan’s economy”


    Has anyone got a calendar in terms of US political decision regarding fiscal policy etc ? (proper) fiscal stimulus application seems to me the sole and only solution. BUT it will not avoid paying, to a certain extent, for housing bubble.

  • Christian Glupker

    First, good Macro 101 summary. Clearly explained in minimal time.

    Personally, I believe the risks of QE2 out-weigh the remote possibility that it will work. Obviously deflation is a big concern, although the impact of deflation can be over-stated sometimes. Lower prices increase buying power, which increases output. Obviously businesses won’t take kind to the reduce margins so you could see job loss as they look to regain margins via labor reduction or out-sourcing. It really depends on the extent of deflation.

    Inflation is much more dangerous, especially hyper-inflation. Think of a tornado watch. The conditions are right for a tornado, but at this time we may not see one. We can’t look at QE1-2 and not ignore the huge threat of inflation. The growth in monetary base alone is enough to put up the warning sign.

    The real reason I don’t believe QE2 will work is exactly what you stated: rates are already low and consumer confidence is weak. Businesses are not investing at these historically low interest rates. I work in corporate banking (and teach economics) and will tell you it’s an investment ghost town out there. Top reason for lack of investments: healthcare reform and government spending. There is no clear indication of how much this new health care will cost businesses. Also, with the government spending, businesses are concerned about tax increases. So instead of investing, they are waiting to see what happens with healthcare and taxes. With the lack of real investment, these low interest rates will likely create another speculative investment bubble.

    Consumer’s won’t spend until they have job security so business investment is the key to economic recovery. Even with job security, consumers consumption will remain low as they pay off debt and correct the household balance sheet (out of whack due to falling house prices). Once consumers are confident in their financial position, discretionary consumption will increase.

    QE2 addresses neither of these issues.

    As for financial institutions being stronger, you are correct. However it’s not because of uncle sam. The financial bailout was a waste of tax payer money because the banks have plenty of excess reserves prior to the bailout. Being a corporate banker, I know this first hand. We stop lending because our balance sheet was imploding. The implosion did not require government bailout. Banks needed to direct man-power to handle these issues. I stopped lending and started fixing bad debt. I also spend time re-writting commercial lending guidelines. We have systems in place to handle bad debt. The huge amount of bad debt stopped lending ONLY because manpower required. We had PLENTY of excess reserves.

    Also, going into a recession, we were expecting savings rates to increase, thus adding to our excess reserves. This is exactly what happened. I work for one of the top ten banks in the country. We wanted nothing to do with the bailout, but were basically forced to take some of the money to set an ‘example’ for other banks (that’s a whole different conversation)

    note:typed on an iphone so please excuse poor spelling and grammar.

  • Christian Glupker

    From 11/8 to today, yield curve has increased approximately 30bps (10+ year). The 5-7 year increased roughly 40bps. This has increased banks cost of funds, thus interest rates. Investment is being crowded out.

    I have a multi-million investment just tabled because of the rate increase. The business is going to wait to see what happens to rates. This investment would have created five new jobs. Not much, but multiply this across the macro economy.

  • Nils

    Well a tax cut is usually perceived as permanent, so it is spent or saved according to the household budget. If you get 900$ just once you might as well spend it. In the case of the US most would probably rather pay down their credit card debt or something like that.

    It might be interesting to study that a bit further, some countries handed out credits, some cut taxes, so we could now check how that has affected consumer spending.