Tuesday, 10 August 2010

Is QE deflationary: an update

Turns out quantitative easing is deflationary - at least the Federal Reserve thinks so.

Today the Fed announced that the interest and capital repayments from the bonds it bought last year will not be retired from the system (which would reduce the money supply). Instead, they will use them to buy new Treasury bonds.

Via Mark Thoma:
...the Fed will keep “securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities”
Now I hate to say I told you so, but I told you so...

There is, however, a point more important than my self-satisfaction: whether this policy will work. Unfortunately this policy adjustment appears to reveal a basic uncertainty in the Fed's goals. By making ad hoc adjustments like this, the Fed keeps the rest of us off balance - we don't know what it will do next because its signals are too vague.

In some cases this kind of policy is desirable - regulators and governments may want to create a degree of uncertainty in order to avoid people gaming their rules. But with central banks, the best strategy is - probably - to tie themselves to the mast. Predictable monetary policy - whether expressed in terms of NGDP, price levels or inflation - allows people to make firm long-term contracts relating to nominal prices and debt.

The Fed would be better off announcing what objective it wants to achieve, rather than trying to fiddle the dials to achieve it by surprise. Otherwise, the credibility Ben Bernanke is so keen on will be diminished - by lack of understanding of what the Fed wants, if not by lack of belief in its power to achieve it.

Update: the FT Money Supply blog has a little more on this, as does Lex (subscription may be required for Lex, which is lucky because it's a bit depressing).

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