With Bernanke’s speech today at Jackson Hole, QE3 is in the news. Yesterday Izabella Kaminska at Alphaville wrote about the Fed’s use of Jedi mindtricks — its influence on market expectations — and rightly noted that one of the important impacts of any additional QE would be its effect on market expectations. Agreed.
But a couple of times now she has made reference to her belief that QE3 “might only prolong the liquidity trap or make it worse.” I’m trying to understand the argument, and I’m not sure that I get it. When I hear the term “liquidity trap”, I think about a situation (like the present) in which nominal short-term rates have been pushed down to zero, so conventional monetary policy has no impact on the economy. By selling short-term assets and buying long-term assets, how exactly would a new round of LSAPs by the Fed make the liquidity trap worse?
More generally, I have yet to see a convincing argument for why QE3 would be a bad idea (in the previous post I explained why I find Woodford’s arguments unconvincing, for example), and I can see a couple of ways in which it might help.
1. Market expectations. First, as Kaminska and others have pointed out, additional QE (or LSAP, which is the more accurate name) could have an impact on market expectations. But that’s a good thing. Anything the Fed can do right now to communicate that it will do work hard to avoid further disinflation, and that in fact it is willing to tolerate a bit of inflation, will help to spur new spending.
But I think it’s just as important to remember the rather prosaic but very real impact that further QE would have on long-term interest rates. As I’ve summarized before, there are a number of rigorous empirical studies that show that the Fed’s QE programs had a significant impact on long-term interest rates. And if QE can push long-term interest rates down, it can have additional positive impacts on the economy through a couple of channels.
2. Help push investors out of US Treasuries. For one, driving down long-term Treasury rates will, at the margin, push some investors who have been parking their cash in government bonds to move their wealth into other assets. Anything that persuades investors to take on a bit more risk, undertake new investments, and lend money to businesses and individuals has to be a good thing. (Yes, this is another way of saying that QE pushes down interest rates throughout the economy, not just in the market for US Treasuries.)
3. The housing market. Perhaps more importantly, lower long-term interest rates lead directly to lower mortgage rates. And mortgage rates have a well-established and signficant impact on the housing market. (See, for example, this 2008 paper by Clayton, Miller, and Peng (pdf) for some recent empirical estimates of the impact of mortgage rates on house prices and transaction volumes.) Since the housing market is probably the sickest part of the US economy right now, and is certainly a serious drag on economic growth (as highlighted by Bernanke in today’s speech), there’s every reason to think that pushing down long-term interest rates could have some real positive effects on the economy.
So yes, Jedi mindtricks are important, but there are other mechanisms through which QE3 could have a real, positive impact on the US economy. It would not be a miracle cure, of course, but it would have a positive impact at the margin. And at this point, we should be happy to take whatever we can get.