I had thought that early iterations of quantitative easing were flawed because they were based on a fixed amounts of total purchases. The size and length of the programs were effectively arbitrary as they were not linked to economic outcomes. This, combined with clear indications that policymakers desired to reduce the balance sheet as soon as possible, meant that the Fed was not able to sufficiently affect longer- term expectations about the future price level or inflation to yield sustained improvement in economic activity.
In effect, the Fed was shooting itself in the foot with temporary programs. I had thought that open-ended quantitative easing tied to economic outcomes would resolve the problem of stabilizing expectations of future inflation, thus supporting a "stronger and sustainable" recovery. The initial gains in inflation expectations seemed to justify such optimism. But a funny thing happened on the way to the show -- inflation expectations reversed course:
TIPS-measured inflation expectations began falling in March, and now stand at pre-QE3 levels. Also telling is the Cleveland Federal Reserve Measures of inflation expectations. Longer-run expectations remain well below 2%:
Arguably, by these measures a lot of policy has gone into accomplishing very little. The Fed, however, will tend to take solace from the Survey of Professional Forecasters:
The median is hovering near 2%, but at the bottom end of the range. So even if financial markets are anticipating lower inflation, professional forecasters are not. But professional forecasters really have not deviated from 2% since prior to the crisis, whereas the Fed has seen sufficient numerous threats to price stability to engage in repeated asset purchase programs. So one wonders how much weight the Fed places on this measure. Or, probably more accurately, they place more weight on this measure when it suits their purposes, such as if they are interested in ending the asset purchase program.
Form the perspective of policy, however, I am not so confident the survey is the best measure of inflation expectations. The Federal Reserve transmits policy through financial markets, and if those markets are not signaling stable or, more importantly, higher inflation expectations, then it is arguable that by itself quantitative easing has limited impacts on economic activity. It can put a floor under the economy, but not accelerate activity. Perhaps at best, quantitative easing does not cause higher inflation. At worst, some argue it is actually deflationary. The latter argument, however, will not get much support at the Federal Reserve, at least not yet.
Alternatively, one could argue that the Fed can indeed affect inflation expectations and really what is going on is that the Fed botched policy. Again. This is the "they have some slow learners on Constitution Avenue" story. Inflation expectations turned down in March, just when the Fed started sending signals that tapering was on the horizon. In this story, the Fed extrapolated a handful of data into the future and decided enough was enough. But that data was endogenous to Fed policy, and threatening to remove that policy once again undermined the economic outlook. In short, just by talking about tapering in an uncertain economic environment, the Fed pulled the plug on a successful policy.
But what should the Fed do now? Can they reverse the decline of inflation expectations merely by ending expectations of tapering? I am somewhat doubtful; the cat is out of the bag. They may very well have to expand asset purchases if they want market participants to believe "no, we were just kidding." Indeed, I suspect that at least one policymaker -- current voting member St. Louis Federal Reserve President James Bullard -- would push for expanding asset purchases given the inflation and inflation expectations data. It would be interesting if he dissented a "hold steady" statement at the next meeting on that basis.
There will be, however, strong resistance to raising the pace of asset purchases. Yes, I know the Fed said they could move up or down. But I think the idea of "up" would only come after a "down." And clearly, if inflation expectations are any guide, market participants are getting the message that "down" is what is coming. And they are not getting that from just the hawkish policymakers. The doves too have been getting in on the action. Moreover, I have to imagine that the recent market action in Tokyo has made some policymakers a little bit nervous about the limits to quantitative easing. The Nikkei's rise and fall seems to indicate that at some point asset purchases do in fact become destabilizing.
My view is that asset purchases would be most effective if coupled with fiscal stimulus. Working only through financial markets may be simply too restrictive to yield broad-based economic improvement. It is almost as if the Fed is trying to force a fire hose of policy through a garden hose. Keep turning up the volume, and eventually that hose bursts. And that might be what we are seeing in Japan.
Bottom line: Inflation expectations are falling, and that by itself should complicate the Fed's expectation that they can start scaling back asset purchases at the end of the summer. But falling inflation expectations may complicate monetary policy more broadly by revealing the limits to quantitative easing. And Japan isn't helping.