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QE3 Commentary

September 18, 2012

I am really behind the QE3 commentary curve, so I’m not going to try to do a long winded post. Instead read Scott Sumner, Eli Dourado, Bill Woolsey and George Selgin.

The big advantage of the Fed’s new action is that at long last they said “we will do X until we get result Y“. The Fed should not say “we’ll print $50 billion and see what happens”. That’s just as silly as a driver saying “I’m going to rotate the steering wheel by 45 degrees no matter what happens”. The Fed needs to base policy on actual economic conditions, not on their estimates of what could happen a year from now. You can either drive your car by looking out the front window or the rear view mirror. After 4 years of crashing their car into everything they come across, the Fed has finally said “we’ll turn the steering wheel until our car is in the lane”, but they are still looking at the rear view mirror.

The Fed has promised to buy only mortgage backed securities. When the Fed adds money to the economy, they do it by purchasing some asset. When they buy something, they increase demand for it, and raise its price. Normally, the Fed buys Treasury bonds, which lowers the cost of borrowing for the U.S. government. In theory, this does not affect relative prices very much, since the government buys a large variety of goods and seigniorage is a relatively small part of government revenues. Mortgage backed securities are a fairly large, liquid market, but even so the Fed is distorting the relative price signals and giving a handout to the current holders of mortgage backed securities. The Fed is incentivizing the overproduction of these securities, which got us into trouble in the first place. Any way you slice it, it is hard to justify limited Fed purchases to this one type of asset.

The Fed seems to be saying that they will target employment, rather than a price. We tried this once, and it will probably fail again. You can’t target quantities with monetary policy, you can only target prices. When you try to target a quantity, and the market is limited by real factors, all you get is runaway inflation. I don’t think the Fed will actually induce stagflation, but their policy as stated would create it. QE3 seems a like one step forward and one step back down the road of crony finance.

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