Friday, June 15, 2012

The debate surrounding QE3

The bleak May unemployment figures from the US highlights attention on the perils facing a recovery from the Great Recession. President Obama has renewed calls on the Congress to pass his $447 bn Jobs Bill. In fact, as the labout market shows no signs of picking up sustainably, there looms the possibility of a large number of the long-term unemployed becoming ineligible for their unemployment insurance benefits.

But the bigger interest is on whether the Fed will step in with a third round of quantitative easing. Supporters argue that the Fed still has considerable fire power to credibly commit to keeping interest rates low for a sustained period of time, much longer than what is being done now.

However, there are reasons to doubt whether further loosening will be of any benefit. Given the bruised household balancesheets and anemic investment climate, the monetary base expansion is piling up as banks' reserves instead of being lend for consumption and investment. In a recent op-ed Lawrence Summers summed it up nicely,
However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.

There is also an oddity in this renewed emphasis on quantitative easing. The essential aim of such policies is to shorten the debt held by the public or issued by the consolidated public sector comprising both the government and central bank. Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates – exactly the opposite of what central banks are doing. In the U.S. Treasury, for example, discussions of debt-management policy have had exactly this emphasis. But the Treasury does not alone control the maturity of debt when the central bank is active in all debt markets.
Further, any quantitative easing runs significant risks. As I have blogged earlier, the ultra-low interest rates have generated several resource mis-allocation problems. A bond market bubble in safe haven assets, induced by the flight to safety and liquidity, is inflating. The corollary to this is the mirror image reversal of rising yields associated with the vulnerable economies. Managing the exit from such mismatches throws up another set of problems.

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