Defending the Fed against GOP sabotage

[ProSense]

Faith in the Fed: QE2 Will Not Spur Inflation

By MARK THOMA

Although the economy appears to have finally turned the corner, most analysts foresee a very slow, agonizing recovery ahead, particularly for employment. In light of this, the Fed has initiated an additional round of quantitative easing to improve the prospects for recovery. However, many people — conservatives in particular — have expressed strong opposition to the Fed’s plan.

Why are conservatives so opposed to the Fed’s plan to help the economy? As is clear from the 23 economists who signed a letter protesting the Fed’s move, the main concern is inflation. Worries about inflation are also behind a proposal from Rep. Mike Pence of Indiana to change the Fed’s dual mandate of stabilizing both inflation and employment to a single mandate of price stability.

The Fed’s plan, called QE2, requires printing new money and using it to purchase long-term Treasury securities from the private sector. The increase in the money supply that results from these purchases is potentially inflationary.

However, inflation won’t be a problem until the economy recovers. So long as the economy continues to struggle, there will be little demand for loans to finance new investment or the consumption of durables, and the new money the Fed creates will simply pile up in banks as idle balances. This means that the inflation problems the GOP is worried about can be avoided if the Fed reverses its policies once the economy improves, something it has assured us it will do. The worry about inflation is really a worry that the Fed won’t reverse course and undo the quantitative easing once the economy begins doing better.

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Krugman: Sabotaging QE

When short-term interest rates are up against the zero lower bound, whatever power the Fed has to influence the economy comes largely from its ability to affect expectations. This is true even for Bernanke-style quantitative easing: you can’t really push down longer-term yields unless the market believes that you’re going to keep buying until the rates are where you want them. It’s even more true when it comes to credibly raising expected rates of inflation.

So if a large political faction begins yelling and screaming as the Fed attempts QE, this will have the effect of undermining the policy’s effectiveness. And so it’s proving.

[DCKit]

1. Don't know what to think of the QE plan, but don't believe Goldman Sachs...

should be acting as the middleman and reaping a profit from this sale.