Following the announcement of a third round of quantitative easing by the Federal Open Market Committee (FOMC), inflation hawks were quick to pounce on the immediate spike in inflation expectations. From their vantage point, the increase in expectations was a key response that signaled QE3 is going to stunt future economic growth. The rise in inflation expectations, however, is a method the Federal Reserve is purposely using to accelerate investment spending and both current and future economic growth.
A paper presented at the Jackson Hole Symposium by Columbia University Professor Michael Woodford showed that asset purchases by themselves had done little to stimulate the economy. Simply put, the paper asserted that depressing the yield curve by buying Treasuries and mortgage-backed securities was not enough to accelerate economic growth.
Instead, Professor Woodford advocated that the Fed should increase its forward guidance by stating monetary policy will remain loose even as the recovery starts to accelerate.
One method would be to tie monetary policy to a nominal GDP target using a Taylor-type rule. In this case, medium bouts of inflation would have no effect on monetary policy and participants would know exactly when tightening would begin.
In effect, the Fed would welcome inflationary pressures as long as the nominal economy was growing at substandard rates. Thus, inflation expectations would rise, which would drive down real returns on savings and promote near-term spending. Therefore, the gains from quantitative easing are a result of savers determining they are better off spending in the short-term rather than accepting negative real savings rates.
Once the economy adequately recovers, the Fed would tighten policy, slow growth, and ultimately reduce the inflationary pressures brought on by its forward guidance.
The FOMC did not advocate for a new type of Taylor rule in its September 13 policy announcement. It did, however, tie monetary policy to employment rather than inflation by explicitly stating "that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens." In effect, the FOMC is comfortable with inflation getting above its target range as long as the employment situation remains below a satisfactory level.
The Fed relegated the inflation portion of its mandate to the background.
The effects were immediate on inflation expectations.
Inflation expectations jumped by an average of 20 bps across the curve from Sept. 12, 2012 -- the day before the FOMC announcement -- to Sept. 14, 2012 -- the day after the announcement. Yearly CPI growth over the next five years was expected to average 2.3%. Growth over the next 10 years was expected to average 2.6%, which is above the Fed's implied CPI inflation target rate of 2.5%.
Those gains, however, were not maintained. Inflation expectations returned to pre-announcement levels by the end of November.
While the Fed is deliberately trying to reduce real savings rates, near-term real savings rates are currently at their highest level since before QE3.
The stimulus effect from quantitative easing on Treasury yields -- i.e. lower real returns -- has completely evaporated on the economically crucial short-term portion of the curve. The incentive to spend today and to provide a boost to the economy has vanished.
Unless the Fed can spur higher inflation expectations, the positive effects from quantitative easing will continue to diminish.
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