QE works – expect more of it

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There’s a lot of crap being written about monetary policy at the moment.

Take this from the FT, which says easier policy is not necessary as private sector employment is still expanding. This is nonsense.

What matters for monetary is the central bank’s inflation forecast. The two things that drive this forecast are inflation expectations and the difference between the economy’s potential output and the current level of output (the so called ‘output-gap’ — think as the outcome of a horse race between demand and supply).

Right now, inflation expectations are falling.  Since Q2, the demand horse has been running more slowly than the supply horse (approx the sum of productivity and population growth) – which is why the unemployment rate has been basically unchanged (9.7% in March, 9.7% in May, 9.6% in August).

More subtly, the Fed’s forecasts are too optimistic, and the downward revision is an argument for easing.  As the growth numbers come down, the future output gap increases in girth, and hence expected future inflation falls.

Thus, assuming we start with optimal policy, growth that’s below forecast – but above trend – could be a strong argument for easier monetary policy.

There is another bit of tosh is this editorial – the argument that rates are already so low that lowering them won’t make any difference. This is the sort of marginal / average confusion that is made by novices – the FT ought to know better.

Cheaper money is cheaper money. There are always projects at the margin that become economic when rates are lowered. Also, cheaper money tends to boost asset prices – and with house prices falling once again on most any measure (FHFA, Radar-logic) falling asset prices could be a problem once again.

Finally, even in the limiting case where there were no marginal borrowers, there are almost certainly re-financers. The government constantly rolls over debt, so lower interest costs for them mean lower taxes for you and I. Avoiding the deadweight losses associated with higher taxation means that lower rates are good for growth, even if no one borrows anything more.

Back in the real world, it’s almost certainly the case that existing mortgagors and companies will refinance their existing debt – lower interest rates for them means they can either pay off their debt more quickly or spend some of the money they save from their monthly repayments.

They’ll probably do a bit of both.

The Fed gets this – they are putting out the word the QE2 is on the way.

FT Harding and WSJ Hilsenrath dropped heavy hints that the Fed is unsatisfied with recent growth performance, and is likely to take out additional insurance.

I think they will. I ascribe a 75% chance to such a move at their November meeting.

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