On Thursday, the Federal Reserve announced a big party called Quantitative Easing III. Officially, they are “purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.” Despite reading dozens of tweets, news articles, and blog posts, I still have no idea what that actually means.
The investors seem to love it, because the stock market is booming. The elites think it’s a free lunch, a win-win-win barrel of awesome sauce that’s going to save the economy or something. The doom-peddlers think it’s a reinflation of distorted bubbles that’s going to backfire into a terrible collapse or something.
But what does it all mean? The Fed’s announcement said it’s supposed to “put downward pressure on longer-term interest rates.” Ah, so interest rates must be going down! Interest rates have been at record lows lately, although they’ve come up a bit in the last month or so. For example, the 10-year Treasury was flirting around 1.5% but was up to 1.7%. All it’s done since the announcement is climb up to 1.87% since traders who loved the announcement switched from bonds to stocks. Ah, so interest rates must be going up! But the Fed is actually buying mortgage thingies which means “Economists believe QE3 will take [mortgage rates] lower.” Ah, so interest rates must be going down! But economist Justin Wolfers says I should refinance “now,” and I wouldn’t want to do that if rates were about to drop some more, right? Ah, so interest rates must be going up! But if they’re going up, than that makes it harder for people to afford houses, and the Fed says they’re trying to “support mortgage markets.” Ah, so interest rates must be going down!
Are you as confused as I am yet? Maybe certain kinds of rates are supposed to go down while others go up? There does seem to be a general consensus that this will lead to some sort of higher level of inflation. But I’m not really sure, and I’m getting tired of trying to figure it out. I bet Ben Bernanke is sure, though. He’s pretty smart.
The point is to keep long term interest rates low. Whether it does that or not is anyone’s guess (OK, to be fair, some people can guess better than others). So, you are right, time will tell if this works or not. Furthermore, it isn’t clear whether keeping long term interest rates low will boost the economy anyway.
The big concern, as it has been for years, is not inflation, but deflation. If we get widespread deflation, then we could get a depression. Not pretty.
On the other hand, a little widespread inflation would be just what the economy needs right now. Housing prices would rebound, wages would increase and employment would follow. The big drawback would be that things cost more. Especially if our currency weakens. That French wine will cost you more. Boo hoo. Not ideal, but not the worst thing in the world, either.
The big problem is the Fed has very few options. Normally, when the economy hits a slump, they lower interest rates. When the economy overheats and inflation becomes a problem, they raise it. But right now, it is as low as it can go. Thus, they are stuck with these weird instruments, all the time waiting (and probably wishing) that the government will spend its way out of the recession (which is what standard economic theory prescribes).
Deflation may be bad, but I don’t see any evidence that we’re in danger of reaching it. Inflation has been running at just over 1% for awhile, gas and food has gone up a lot, and house prices are already rebounding. More inflation and/or weaker dollar doesn’t just impact French wine but all kinds of food, energy, and manufactured items, hurting the poor and also penalizing savers. I’m not saying it will be disastrous, and maybe it will lead to more employment, but I’m not really convinced of anything yet.
Yeah, we’re probably going to avoid deflation, but not by much. We certainly had it in some sectors (housing, wages, etc.) but missed widespread deflation by a hair. As you said, inflation has been hovering around 1%, this means we missed it by a bit over 1% — if my math is correct 🙂
With regards to inflation, I should have been more clear. Most of the inflation that we have seen in the last twenty years was caused by commodity shortages. Energy and food come to mind, but there were others. These tend to really hurt the economy and there is little the fed can do about this, except try and slow the overall economy. They did that back in the “stagflation” days. Despite the fact that unemployment was high, they raised interest rates to such a high level that it pretty much killed inflation, despite the fact that it wasn’t an overheated economy that was driving it.
When I say “widespread” inflation, I mean something we haven’t seen in a long time. I mean wages going up along with goods and services. I was a bit glib about the cost of this, but I still say it isn’t that bad. If wages rise along with costs, then who is hurt? Those on Social Security or pensions tied to inflation will see their income go up. Folks with money in the bank will see their rates go up as well (to match inflation). Stocks tend to go up with inflation (especially if it is an overheated economy that is driving inflation). Home owners who are paying a fixed rate mortgage come out way ahead (regardless of the value of their home). Long term bond holders get screwed, but that’s why everyone says you should have a balanced portfolio.
A weak dollar is a different matter. There are many more losers, especially the poor. Imported goods cost more, and many of those imported goods (like oil) hit the poor harder when the prices go up.
Despite all this, you have to come up with a pretty high inflation rate to suggest that things would be worse than right now (let alone the height of the recession). The working poor right now are not too happy. I’m sure most of the folks that are poor (or folks in general, for that matter) would gladly trade the current conditions for an unemployment rate of 4% even if it came with inflation at 5%.
Which brings me to Greece. This is a great example of why the Euro is such a mess. If Greece had its own currency, it is pretty easy to see what would be happening. Inflation in the country would be high. The value of their currency would plummet. In other words, the average Greek would be a lot less wealthy. However, things would be a bargain in Greece. People would travel their in waves — being able to afford a nice Greek vacation for the price of staying in Mexico. Greek exports would also soar. Unemployment in Greece would drop quickly. In other words, everyone would take a big hit (from a wealth standpoint) but then things would quickly rebuild. It is only the artificial nature of the Euro (many governments, one currency) that is preventing this from happening.
Fortunately, we don’t have that problem here, yet we still fear the inflation boogeyman (and the country pays the price).
Some of this confusion is probably fixed by looking at real yields (all going down) instead of yields. This requires getting people to confront the reality of inflation though which may be why it isn’t played up.
The one I can’t make mesh well with the others is the advice that you’re supposed to refi ‘now’. If it’s sincere advice it doesn’t seem accurate for the reasons you say (and also because, supposedly, a more-than-inflation housing boom will be coming; why refi now when your home value will double in 2 years and rates will be ~the same?). If it’s some sort of trick to further ‘Keynesian’ aims (‘even though it’s bad advice on a micro level it helps our macro aims so I want a lot of people to do it’) I don’t quite see the motive.
Macroeconomics is more art than science. How familiar are you with Scott Sumner’s work? I find that if nothing else, his writing is much clearer than anyone else on what matters and what does not.
Interest rates are a price, and you shouldn’t reason from a price change. The Fisher hypothesis suggests that OMOs can either raise or lower the nominal interest rate because the real interest rate will go down because the central bank is supplying loanable funds, and expected inflation will increase. Instead market monetarists focus on nominal spending:
OMOs increase spending -> Spending causes higher NGDP which can show up as either inflation or real GDP depending on the slope of the aggregate supply curve
I should probably start reading Sumner’s blog. I tend to find myself more interested in news and data than in abstract theoretical stuff, but then I guess I shouldn’t complain too much when I don’t have the theoretical background to understand the news. I do find intriguing the idea that “higher NGDP…can show up as either inflation or real GDP depending on the slope of the aggregate supply curve,” thanks.
It’s not deep and insightful or anything, it’s just an identity: P*Q is higher because P is higher or Q is higher or some mix of the two. Let’s say you run a firm. If you get higher sales than you expect you might simply raise prices, or you could expand output. In a purely flexible price world, you’d raise prices; in a sticky price world, you’d increase output.
Any theory of central banking asks “when should the central bank print more/less money?” Market Monetarism answers: “Print until you hit a NGDP level target.” Level targeting ensures that past mistakes are corrected instead of the trend being a random walk. NGDP puts equal weight on inflation and real GDP changes in determining how the central banks change the money supply. Emphasis is also put on using market predictions of macroeconomic variables rather than magical occult techniques, such as VARs. Targeting spending also targets income, which allows people to pay back their debt obligations, no matter how far real GDP falls. Anyway, as you can probably tell, I’m pretty sympathetic to market monetarism.