The US Federal Reserve really delivered today. Its chairman Ben Bernanke announced QE3, but with very big differences to other QE operations. This time QE is open ended. For the first time they are signalling what they want to happen instead of signalling what they will do without specifying what they want to happen. This is almost exactly the sort of thing which needs to happen in the UK.
The most important part of monetary policy is manipulating expectations. Current policy signals future policy. The sum of future policies is several times more important than current policy, hence what current policy tells us about the future is far more important that how current policy mechanically effects us now.
For example, when investing in a structure of piece of machinery that will last decades today’s interest rate doesn’t really matter, what matters is an assurance of healthy demand in the medium term. It is that signal of healthy demand that is monetary policy maker’s greatest tool. The Fed are beginning to behave like that is true.
Mechanically, QE is very similar to the normal monetary policy mechanism. Normally, the central bank tells markets where it wants interest rates to go and they go there. Chuck Norris doesn’t need to hurt anyone to clear a room, he just tells people to get out. A central bank is like that, except with printing presses not bench presses. QE should be the same, mechanically, as normal policy but it has been something of a failure in ending our stupor. It has failed because the world’s central banks are very good at signalling with interest rate moves, but very bad at signalling with QE.
That has now changed.
Today Bernanke announced that the Federal Reserve would purchase $40bn of agency mortgage backed debt every month. In previous rounds of QE they announced how much they would buy, but not what they expected to happen. This time the language has changed.
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
Strongly expansionary policy produces a rapid recovery which produces expectations of tight
policy, which prevents policy from being as effective as expected. There is a reflexivity problem
in monetary policy which Yglesias explains well: Success begets failure.
The Fed are trying to get round that by saying a recovery won’t change their mind straight away. They aren’t saying exactly what they want to happen, they’re too cryptic for that unfortunately, but they are saying they will not tighten policy at the first signs of recovery. This sounds minor, but look at the leap in the stock market:
No, the stock market isn’t the labour market, but stock markets move quickly and labour markets don’t, and stocks liked the news. Bear in mind as well, that stocks were higher on the strong expectation that policy would become looser. Policy turned out even looser than expected, hence the jump.
If Mervyn King’s replacement – I’ve given up on Britain’s Worst Central Banker – can do something similar, he could be worth £250bn to all of us. All he has to is follow Bernanke’s lead and convince people he is serious about helping people.