QE2 and Beyond

   As everyone awaits the announcement of another round of quantitative easing, the primary questions seem focused on the size of the package. For those less concerned with the size, questions revolve around the effects of further easing. Regardless of the size or effects, it seems appropriate to consider what may happen if QEII's impact is not significant enough or even fails outright. In search of some answers, it appears Ben Bernanke may have outlined the future actions in May 2003, during a speech before the Japan Society of Monetary Economics. Bernanke offered Some Thoughts on Monetary Policy in Japan, which outlines specific measures he believed the Bank of Japan (BOJ) could take to end the deflationary cycle.

   The initial part of Bernanke's plan prescribes setting a price-level target for the economy. The target would be generated by presuming that a preferred level of inflation had persisted from the onset of the deflationary period. Providing this target would signal the central bank's intentions to pursue quantitative easing until prices reached or came close to the targeted level. Initiating a target would also provide a consistent measurement for judging the BOJ, contrary to individual year assessments of price stability. Some risks, he suggests, with such a plan are inducing excess inflation and/or negatively impacting the central bank's balance sheet. Although Bernanke views these concerns as negligible, further consideration in regards to the U.S. appears warranted.

  Let's first consider the latter of the two issues, the effect on the balance sheet of the central bank. At this time, Bernanke argues, for several reasons, that the balance sheet should have little effect on deciding monetary policy because the risks can be offset or negated fairly easily. While this may be true in Japan, although they've yet to attempt Bernanke's plan, there are critical differences between Japan and the U.S. which require pause. The primary difference, in regard to the national debt, is the percentage of debt held by foreigners. While only a few percent of Japan's national debt is held by foreigners, the U.S. relies on foreigners who currently hold approximately 45 percent of the publicly held debt. This is critical, largely because of the expected impact quantitative easing has on a currency's value. From an economic stand point, lacking a similar increase in the demand for a currency, printing more or increasing supply of a currency will reduce its value. A country's citizens likely have limited options but to invest in securities denominated in the local currency. However, foreign citizens and governments don't face the same constraints and may become wary of investing in a declining currency. Were foreign investment to dry up due to a weakening dollar, the government could have trouble selling U.S. treasuries, leading to rising interest rates. Depending on the size and make up of asset purchases by the Fed, future Treasury auctions could instead effectively become a transfer of debt between the Treasury and Fed. Equally troubling, this could ignite fears the U.S. was monetizing its debt, leading foreigners to sell their dollar-denominated assets, pushing the dollar's value down further and sending interest rates higher. Americans currently appear to take future foreign investment for granted and with good reason. A word of caution though, changes in sentiment are often sudden and unexpected, but once they occur can be extremely tough to counteract.

  The other point made by Bernanke that I feel deserves further attention is the possibility of runaway inflation spurred by excessive money creation. Given our basic knowledge on the effects of deflation versus inflation, I'd certainly agree that inflation is a far more manageable problem to face. Therefore, while entrapped in a deflationary state, excess inflation would appear to be a minor cost for escaping the current struggles. While Japan remains in a deflationary cycle seven years later, the U.S. is currently suffering from disinflation, not deflation. This is important, as it likely means the chances of runaway inflation from similar policies are higher. My primary concerns with the notion of setting a price-level target relate to the exit strategy. Quantitative easing's impact in creating inflation can typically only be measured on a lagging scale. Therefore, although the central bank may stop easing once the price-level nears the target, future inflation created by the actions may send the price-level well beyond the target shortly after. Provided the track record of the Fed since Alan Greenspan took the reigns, it's hard to imagine the Fed moving quickly to counteract high inflation were the price-level to move significantly above target. On this point, would the target even remain in place once it had been reached? If not, the Fed would be installing a similar plan as used in determining cost of living adjustments (COLA) for Social Security. The problem with both plans is that, in the long-run, the price level ends up far higher than would be the case were a stable inflation rate to persist indefinitely. As Bernanke, even admits in his speech, inflation is ultimately a form of tax on the citizens.

   As Bernanke lays out in this speech, it would seem as though the potential sizeof quantitative easing announced at this juncture is rather inconsequential. Were the current plan to fail in fully achieving the desired result, one would expect little hesitation on Bernanke's part to continue quantitative easing indefinitely. While the end outcome of the proposed solution is unknown, one must wonder why the BOJ has not attempted this plan despite their continued failure using other measures. Maybe they believe the noted costs would be much higher or more likely? Maybe there hesitation is for other reasons not considered in this speech? Maybe they are just unwilling to take such a big leap of faith? In any case, to date, price-level targeting remains an idea rather than a practice. Depending on the outcome of this week's announced actions, it may become practice of the Fed in the not too distant future.