Even Felix Salmon is against QE, on the grounds that it will do nothing to help the employment situation. This was the reason why I thought, back in the summer, that more QE was unlikely.

But I don’t think the latest round of QE is about employment. It is about inflation (and indeed, that is how the idea was originally presented in board members’ speeches, with employment coming in later). This is what I think is happening. Ben Bernanke sees a real risk of deflation in the US. Deflation is very hard to escape: yes, in principle, the Fed could buy the equity market, or the housing market, or raise its inflation target, or who knows what else. But these things are politically impossible. And if deflation took hold, the employment situation could get even worse than it is today. In addition, with the normal rotation of FOMC voting positions, there will be more hawks on the board next year, which will make it harder for Mr. Bernanke to embark on QE then.

It therefore makes sense for QE2 to start now. The idea is to raise the price of financial assets, and through a wealth effect (US households own a lot of equities and know how they are performing) to depress the savings rate (i.e. get consumers to spend rather than paying down debt), and to encourage investment, in order to tide the economy over until the deflation threat recedes. That will not necessarily reduce unemployment compared to its level today, but it will reduce unemployment compared to what it would otherwise have been, had deflation taken hold.

This policy is not sure to work, but given the downside risk inherent in our present situation, it makes sense to do something rather than nothing. If it fails to prevent deflation, we can only hope that the political environment is receptive to more radical solutions when the times comes. If, on the other hand, it works so well that it creates excessive inflation, the Fed has the tools to deal with that problem, in the form of short-term interest-rate increases and the payment of interest on reserves. And there is sure to be no shortage of political support for rate hikes in the face of high inflation.

In summary, the Fed’s current action comes from two asymmetries in its situation.

  1. Political support for tightening is much more likely than political support for easing, so you have to ease when you can.
  2. If you have deflation, you can be trapped; if you have inflation, you can just do a Volcker. So you need to do everything in your power to prevent deflation.
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