Is QE effective? (Please don't ask)
By Scott Sumner
When people ask me whether QE is effective, I know I’m facing an uphill climb. The question is actually pretty meaningless–like asking whether a shovel is effective. For what purpose?
If the question refers to actual real world QE programs, then the answer is obvious. Markets responded to QE announcements as if they were having the effect of boosting NGDP expectations, but not enough to hit the central bank target.
But that’s a profoundly uninteresting question. A far more interesting question to consider is whether QE can be used to achieve any specific nominal target. And the answer is clearly yes. So why is there so much confusion over this issue? The following graph might help to explain the confusion:
Under a fiat money regime, there is often an “indeterminacy problem”. That is, a particular instrument setting might have very different effects, depending on the future expected path of policy. Thus Japan and Venezuela are two countries that do lots of QE, but achieve radically different results. Why is that?
1. Venezuela is the case people have in mind when they think about the quantity theory of money. A policy of printing lots of money leads to very fast growth in NGDP, because it is expected to persist.
2. Japan is the case people have in mind when they think about liquidity traps. At very low rates of expected NGDP growth, nominal interest rates fall to zero and the demand for base money soars. To prevent the economy from falling into a depression, the central bank accommodates this extra demand for base money by injecting more money into the economy via QE programs.
Australia is a “normal country”. Growth in NGDP is high enough to keep interest rates above zero, which leads to very little demand for excess reserves. But not so high that the central bank must inject lots of money to maintain hyperinflationary NGDP growth. Thus Australia does very little QE.
Because of this indeterminacy problem, it really makes no sense to talk about the effect of QE. The same indeterminacy applies to interest rates. Ultra low interest rates might be a very tight money policy leading to the Japanese outcome (if the Fisher effect dominates) or it might be a very easy money policy that leads to the Venezuelan case (if the liquidity effect dominates.)
This indeterminacy problem helps to explain my criticism of a recent MRU video on monetary policy. In the video, Alex Tabarrok points to the extraordinary steps that the Fed took in late 2008, and suggests that in order to prevent a deep recession even greater steps would have been needed. This is like assuming that the function shown above is monotonically upward sloping. Indeed if you asked 100 economists, I’d guess that 99 would tell you that the line slopes up and to the right from the dot representing Japan. But the data suggests pretty overwhelmingly that the opposite is true, the ratio of base money to GDP declines as the NGDP growth rate increases.
Is there a solution to this indeterminacy problem? Fortunately, the answer is yes. Consider three approaches to monetary policy:
1. The quantity of money approach
2. The rental cost of money approach (i.e. interest rates)
3. The price of money approach
Only the third approach is free of the indeterminacy problem. Central banks need to target a price, and then let the market determine how much QE is needed to hit that price. You could think of the price approach to policy as drawing a vertical line on the graph above. It would only cross the QE function once, and hence there is no indeterminacy problem.
For instance, the Fed could target the price of gold, or the price of foreign exchange, or the price of CPI futures contracts. My preference is that they target the price of NGDP futures contracts. With the price approach, QE is always 100% effective. You do enough QE to insure that the market forecast of NGDP is equal to the policy target.
If you are worried about the central bank having to buy too many assets, you simply set a NGDP growth target high enough so that the demand for bank reserves is rather modest.
A Fed announcement that it plans to buy $1 trillion worth of Treasury bonds is not a “policy”, it’s a gesture. It’s meaningless to talk about the effect of this gesture, as it entirely depends on the policy regime in which it is embedded.
A shovel can be effective or ineffective, depending on how it’s used. So please don’t ask me if QE is effective.