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St. Louis Federal Reserve President James Bullard released a very interesting and somewhat uncharacteristic paper last Thursday calling for the return of quantitative easing, QE 2.0 if you will. Quantitative easing is essentially a clever euphemism for the act of printing money.

The crux of the argument is centered around the chart below (source: St. Louis Federal Reserve) which details the relationship between Taylor-type policy rules (black line), the Fisher relationship (red line), and the zero bound on nominal interest rates. Before I lose you let’s define these intuitive ideas. The Taylor rule is a monetary policy rule that stipulates how much a central bank should change the nominal interest rate in response to divergences of actual inflation rates from target inflation rates, it also explains how policy makers change nominal interest rates more than one-for-one when inflation deviates from given targets. The Fisher relationship is the idea that the nominal interest rate for an asset (ex: US government bond) has a real return plus an expected inflation component to it. The concept of zero bound on nominal interest rates simply means that interest rates cannot go below 0%. Now let’s take a look at the graph below which plots inflation rates versus the nominal interest rates for Japan (green circle) and the United States (blue box).

According to Bullard, when the black line intersects with the red line there is a steady state at which the policymakers do not wish to change rates and the private sector expects the current rate of inflation to prevail in the future. This steady state is good for the economy because it provides improved visibility for decision-makers to invest in new projects, equipment, employees, etc. This steady state concept is not particularly interesting or original however what Bullard is concerned about is that these two lines intersect a second time thus creating a 2nd steady state. This 2nd steady state is where Japan has languished for the past 15 years and is characterized by low or no economic growth and little response to policy moves.

Bullard makes a decent case that the US is drifting towards this dreaded 2nd steady state and his solution to prevent this from happening is to bring back quantitative easing. Bullard points out that the May 2010 data point is the closest the US has ever been to the Japanese data points. If you only take away one thing from this article it should be “don’t fight the Fed”. If the Fed truly embarks on quantitative easing 2.0 it would behoove you to buy financial assets immediately. Eight months following our first foray into quantitative easing the S&P 500 (NYSEARCA:SPY) was up +37%, the high yield bond index (NYSEARCA:HYG) was up +25%, and the price of gold (NYSEARCA:GLD) was up +19%.

Disclosure: Long: GLD

Source: QE 2.0: Shift in Sentiment or Classic Jawboning?