Why QE3 Matters

Let me try for a clearer explanation of why the Federal Reserve’s new strategy is a big deal and what the limits to it are.

One basic problem with monetary easing is that there’s a kind of reflexivity problem. When we got some bad labor market news last week, journalists all started saying QE3 is now more likely. But if bad labor market news leads to QE, and QE leads to good labor market news, then QE leads to the absence of QE. A paradox! Or if not a paradox, a situation where expectations about the medium term are indifferent to whether QE happens. The worse things get, the more the Fed will do to reduce interest rates. But the more that interest rate reductions boost the economy the less will be done.

Charles Evans, president of the Chicago Federal Reserve, has been pointing to this problem for a while.

His proposed solution is for the Federal Reserve to offer what he calls “Odyssean” guidance. To say, in other words, that low interest rates are going to persist whether or not the economy improves. That doesn’t give us a guarantee about what the economy will look like, but it does guarantee that more easing will lead to a better economy than would otherwise exist. Evans’ proposal was for clear quantitative goals. Low rates until the unemployment rate drops to such-and-such as long as inflation doesn’t go above such-and-such. What the Federal Reserve offered today was a good deal more tepid than that. But they did say that “a highly accommodative stance of monetary policy” (Fedspeak for low interest rates) “will remain appropriate for a considerable time after the economic recovery strengthens.”

In other words, if the Fed succeeds in boosting the economy, it’s not going to immediately declare victory and reverse course.

That’s good news. But it still does leave an incredible amount of ambiguity. They should get clearer and bolder at their next meeting.