Upon Reflection, Second Thoughts On QE3

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The costs to the real economy of economic policy uncertainty have recently been studied and quantified in a widely cited paper by Scott R. Baker, Nicholas Bloom, and Steven J. Davis. Baker et al. focus primarily on economic uncertainty engendered by fiscal and regulatory measures. Little, if any, attention is paid to the possibility of the negative effects of elevated uncertainty about monetary policy.

The Fed's most recent initiative - QE-3 - includes some unconventional and controversial elements that go beyond straightforward quantitative easing that may increase inflation expectations, while raising uncertainty about the pace of inflation in the future. Specifically, QE-3 makes further stimulus conditional on the outlook for the labor market. The FOMC press release after its September 13, 2012 meeting states: "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." The Fed's same press release also states that, "a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens."

Tying further quantitative easing and other measures to the state of the labor market is a questionable stance for monetary policy, especially in view of the modest and diminishing labor market improvement that has followed a substantial amount of quantitative easing. Further, leaving stimulus in place for a considerable period after the economy recovers suggests a commitment to higher inflation.

There are a number of further problems with the QE-3 approach linked to the additional uncertainty it engenders. First, if the labor market does not improve or if inflation rises prior to any improvements, what will the Fed's response be? Second, is a commitment to leave stimulus in place longer than usual part of a policy of raising inflation and inflation expectations as a means to lower real interest rates as some, though not all, FOMC members have suggested? And third, if inflation does rise, what will be the Fed's response, and will it be able to avoid a destabilizing, difficult-to-reverse rise in inflation expectations? The latter danger is especially real since a rise in inflation expectations is itself inflationary since it induces households and firms to spend faster in order to beat expected price increases.

Higher inflation uncertainty accompanies higher inflation. As a recent paper by Gavyn Davies, Martin Brookes, Ziad Daoud, and Juan Antolin-Diaz states with regard to QE-3, "the introduction of the policy might increase inflation expectations sharply, and raise inflation uncertainty. This could be costly to fix in the long run." Higher inflation uncertainty is dangerous because, among other effects, it boosts money demand as households and firms boost precautionary cash balances in the face of a wider range of possible outcomes of the state of the economy and prices. Since households and firms can only add to cash balances by spending less on goods, services, or capital equipment, aggregate demand is weakened further by a Fed monetary experiment that includes a rise in inflation uncertainty.

The Fed's recent move to QE-3 unfortunately smacks of desperation. Through a number of episodes of quantitative easing that has included a tripling of the Fed's balance sheet, demand has remained weak except when temporarily boosted by fiscal stimulus programs. Adding monetary policy uncertainty to uncertainty about fiscal and regulatory policy will harm the economy and further slow the pace of recovery.

The best course of action for the Fed would be to recommit to price stability, including the commitment to avoid both inflation and deflation. That would include a commitment to ease further if deflation emerged as it did in Japan early in the millennium. Lowering inflation uncertainty is the best way to boost consumption and investment by lowering the precautionary demand for cash of households and businesses. The Fed's commitment to price stability would send a clear message to the Congress that it must reduce fiscal policy uncertainty, perhaps by adopting a framework similar to that outlined in the Bowles-Simpson proposal. Tax reform - tax rate cuts financed by closing tax preferences - along with a stable path toward controlling outlays on entitlements and wasteful programs will improve economic performance by convincing markets that future policy will be better.

Frank Knight observed in his masterpiece, Risk, Uncertainty and Profit: "The use of resources in reducing uncertainty is an operation attended with the greatest uncertainty of all." QE-3 represents the Fed's effort to reduce uncertainty by pre specifying its response to labor market conditions and pledging to maintain a "highly accommodative" stance of monetary policy even after economic recovery strengthens. And the time period over which these commitments extend may exceed the current term of Ben Bernanke as Fed Chairman.

Ask yourself: are you more certain now about the future paths of monetary policy and inflation than you were before QE3 was announced?


American Enterprise Institute resident scholar John Makin writes AEI's monthly Economic Outlook.

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