By Scott Sumner
Ever since interest rates fell close to zero in late 2008, many pundits have expressed skepticism that Fed policy can stimulate the economy. And yet, if the Fed really is "out of ammunition," then why did stocks rise so sharply on the news of QE3? Fortunately the Fed still has plenty of ammunition. The recent policy initiative represents baby steps in the right direction, but the Fed still needs to do much more.
The Fed Isn't Done Yet
Once rates fall to zero, the Fed has two primary tools for impacting aggregate demand, or total spending in the economy. One tool is "quantitative easing" often dubbed QE, or "printing money." In fact, the recent policy is not quite the same as printing money, as most of the new injections are simply commercial bank reserves stored electronically at the Fed. And also because the Fed now pays interest on those reserves, whereas cash does not earn interest. With interest rates being relatively low on alternative investments, the banks are quite content to sit on the new money, which is why bank reserves have ballooned in size. That's not to say that there isn't some amount of QE that would create rapid increases in demand, but rather that the Fed can more easily boost demand using other tools.
The second and more powerful tool is sometimes called "communication" or "signaling." The basic idea is that while the Fed can no longer cut short term interest rates, they can signal an intention to adopt an easier monetary policy in the future, when rates are no longer zero. This will lead to expectations of more rapid growth in demand, which will make people and businesses more willing to spend money today. For instance, people are more likely to buy homes if they think the price of houses will rise over time. And companies are more likely to invest in new facilities if they expect more rapid growth in future years.
[For more on Scott Sumner check out this recent profile of his blog, The Money Illusion, in The Atlantic.]
The best single number to watch for trends in aggregate demand is nominal GDP, which traditionally grows at about 5% per year (3% real growth and 2% inflation.) Over the past four years NGDP has only grown at about 2% per year, the slowest increase in spending since Herbert Hoover was president during the Great Depression. That's far too little growth in spending, and mostly explains the stubbornly high unemployment rate (although structural problems in the labor market also play a role).
Will QE3 Succeed?
The new Fed policy is aimed at boosting spending, to bring down the unemployment rate. The Fed made two key changes, which reflect both its "QE" and its "communication" strategies. In the past the Fed had simply announced a fixed amount of QE, and when that number was reached the program automatically ended. Now they will continue to purchase a specified amount of bonds each month, which will inject new money into the economy until certain labor market benchmarks are reached (perhaps 7% unemployment), or until inflation shows signs of rising to unacceptable levels.
One weakness in the plan is that the Fed hasn't indicated exactly what those benchmarks are, and this reduces the effectiveness of its "communication" strategy. Even so, the open-ended nature of QE3 is one step forward. Recall that when interest rates are near zero, QE is not very effective as banks just sit on most of the new money. So you need much larger monetary injections than usual to produce a significant increase in aggregate demand. Studies show that QE1 and QE2 did boost spending in the economy, but not enough to generate a satisfactory recovery.
The Fed also improved its communication strategy, mostly by promising to maintain an expansionary monetary policy well into the recovery, instead of prematurely raising rates when things get a bit better. The Fed in the 1930s, Japan in 2006, and the European Central Bank last year, all raised rates before the economy was healthy, and in all three cases the economy slipped back into recession or deflation. By promising to avoid this mistake, the Fed hopes to increase consumer and business confidence.
These policy initiatives are still not enough to promote a fast recovery, but as the stock market rally showed, they will probably help at the margin. The next step for the Fed should be to further clarify the benchmarks for future policy changes, to reduce uncertainty in the economy.
Scott Sumner has taught economics at Bentley University for the past 30 years. He earned a BA in economics at Wisconsin and a PhD at Chicago. His research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. He blogs at The Money Illusion.