It goes to the Fed’s motive
Nov 5th 2010, 19:45 by G.I. | WASHINGTON, DC
[Greg Ip] IN COURTROOM dramas, the prosecutor often dredges up some seemingly irrelevant fact about the accused by arguing, “It goes to motive, your honour.”
That’s where the Fed finds itself in today. Quantitative easing is fully justified by high unemployment and falling inflation at home, but the Fed is being pummeled in the court of public opinion because its motives are suspect: other countries think the Fed is trying bludgeon them into assuming more of the burden of global growth via a vastly depreciated dollar.
The latest indictment comes from Sebastian Mallaby, fellow at the Council on Foreign Relations and formerly of The Economist. Mr Mallaby articulates the diplomatic case against QE. America, he notes, has long urged China to allow its currency to appreciate so as to reduce its trade surplus and thus its contribution to the global savings glut and the world’s current-account imbalances:
The Fed’s return to quantitative easing threatens to create a glut of liquidity reminiscent of the mid-2000s savings glut… Already, countries from Brazil to Thailand have responded to the flood of incoming capital by imposing controls and taxes, retreating from the idea of financial globalization. Even before the Fed’s action this week, there was much loud talk of currency war. This now seems sure to intensify, and the United States has lost its moral authority to broker currency peace.
I agree that this is how the world perceives what the Fed has done. But it’s wrong. QE is unconventional monetary policy, but it is monetary policy nonetheless. When either conventional or unconventional monetary policy eases, certain things are supposed to happen: long-term yields fall, stocks rise, the exchange rate declines. All of which is happening now. If the Fed had just cut the Federal funds rate from 3.5% to 2.75% (roughly the equivalent of what its $600 billion in Treasury purchases should achieve), we should have expected exactly the same results, without the sturm und drang about currency wars. There are forms of QE that look more like currency manipulation: unsterilised foreign-exchange intervention, for example, such as the Swiss National Bank and Bank of Japan have both done (and even that is a nuanced case, a debate for another day). But that’s not what the Fed is doing. It is simply trying to do to long-term rates what it has already done with short-term rates.
So what is it about QE that causes the world to impart motives to the Fed that are absent with conventional monetary policy? I think it stems from a misconception of what QE does, as well as an overuse of the term “liquidity”. Purchasing bonds with newly-created bank reserves will only expand the overall domestic supply of credit if banks on-lend the extra reserves. That is not happening: broad measures of bank credit continue to contract. Nor does QE create foreign liquidity; the Fed can do many things, but printing foreign currency is not one of them. If QE works as advertised, the decline in the exchange rate will eventually narrow the US trade deficit and reduce the US demand for global savings (though that will be offset as lower interest rates boost domestic investment and consumption). But that hardly turns it into a contributor to the supply of global savings, much less on anything like China’s scale.
Yes, QE can create bubbles, but through exactly the same channel that conventional monetary policy does: lower US interest rates trigger a search for higher-yielding alternatives, including foreign investments. The Fed does not create Brazilian reals: but it may make investors willing to pay more for real-denominated assets. Before foreign countries try to resist that, they should first ask if they should. Many of these countries need to reorient their economies from exports to domestic demand. A higher currency helps. And if it’s happening too quickly, they can use macroprudential regulation at home, if needed, to cap speculation; and capital controls, if necessary, to attenuate the influx of foreign investors. Like Mr Mallaby I regret the retreat from financial globalisation, but if it substitutes for naked protectionism, I can live with it. One thing other countries should not do is ask America to leave unused one of the few effective policy tools it has left to stimulate the domestic economy. The world needs higher unemployment and deflation in America like a hole in the head.
The original blog post is linked here.