Monetary Policy is About Price, Not Quantity

The mainstream media is beginning to size-up the results of QE2.  And apparently it’s looking like it was all a great big monetary non-event.  This is what I said before QE2 even started, however, it looks like the damage has already been done.  QE2 didn’t monetize anything.  It didn’t cause the money supply to explode.  It didn’t really do anything except cause a great deal of confusion and generate an enormous amount of speculation in financial markets that now appears to be contributing to turmoil and strife around the globe.  But the misconceptions continue.  This weekend the NY Times tells us tells us that QE2 was ineffective mainly because it wasn’t large enough:

“WASHINGTON — The Federal Reserve’s experimental effort to spur a recovery by purchasing vast quantities of federal debt has pumped up the stock market, reduced the cost of American exports and allowed companies to borrow money at lower interest rates.

But most Americans are not feeling the difference, in part because those benefits have been surprisingly small. The latest estimates from economists, in fact, suggest that the pace of recovery from the global financial crisis has flagged since November, when the Fed started buying $600 billion in Treasury securities to push private dollars into investments that create jobs.”

They’re right that QE2 has been a disappointment.  And most certainly a monetary non-event, however, there is substantial evidence now showing that QE2’s one targeted goal – increasing inflation expectations – is working via the exact wrong channels by contributing to the surge in commodity prices (which, I suspect, will only be a temporary event).  So while it’s been a monetary non-event it’s been a substantial economic event.¹

Where the NY Times and economists like Paul Krugman (who is now saying “told ya so” after supporting QE at much larger levels) get it woefully wrong is with regards to size.  There has been a chorus of economists in recent weeks telling us that QE2’s results have been disappointing because it wasn’t large enough (they’re essentially backpedaling from previous assertions that QE2 would do something beneficial). And now that it’s becoming clear that QE2 didn’t contribute positively to economic growth these same economists are changing their tune to give the appearance that QE is not a flawed policy, but that it was merely implemented incorrectly.  This is sheer nonsense.

When I first discussed QE last August and why it would not contribute positively to economic growth I described how QE was akin to an apple salesman who can’t sell enough apples.  So, instead of altering price he merely alters the number of apples on the shelves.  Altering reserve balances at banks is perfectly analogous.  Giving the banks more reserves does nothing because banks are never reserve constrained.  But now all of the experts are trying to convince us that QE just wasn’t tried hard enough!  If only the apple salesman had put more apples on the shelves – then his sales would have improved!  No, that’s not how monetary policy works.  And as I’ve said for many many months now, this obsession with size is entirely misguided.  QE2 isn’t about size.  It is about price.

QE2 was destined to fail before it ever started.  Not because it wasn’t large enough, but because rates can’t be controlled through size.  They are controlled by targeting price.   The Fed controls the short end of the curve by setting the rate.  They do not come out at the FOMC meetings and declare that they will buy $XXXmm in reserves.  They announce that the short rate is X.XX%.

With regards to QE2 the Fed has come out and said they are going to buy back a specific number of bonds.  And the bond market has yawned at the Fed.  In fact, the bond market has spat in their face.  Long rates are higher by almost 100 bps since QE2 started and there is no evidence that QE2 is helping to spur the lending markets as the Fed might have hoped.  Can you imagine if the Fed set the overnight rate at 0.25% and the market just ignored them and took short rates right up to 1.25%?  The Fed would be mocked as a meaningless institution.  But in the case of QE2 we make all sorts of excuses about size, real rates, etc in order to shield their impotence.

Had the Fed hoped to control long rates they should have come out and directly stated their target rate.  They should have done exactly what they do at the short end – stand guard at that rate and challenge any and all speculators to move the rate.  But my guess is they don’t want to do that because they are fearful it will be viewed as a mass monetization of debt (even though the Fed can do no such thing).

¹ – The current iterations of QE are quite different from the current iterations. QE1, for instance, was likely an important and consequential policy move as it helped bolster the financial markets at a time when prices were unusually distressed.