Alan Reynolds and the Straw Man

Alan Reynolds writes in the WSJ this morning:

Federal Reserve Chairman Ben Bernanke may be an excellent economist, but he is not a very good bond salesman. Since his Aug. 27 speech at an annual Fed symposium in Jackson Hole, Wyo., he’s been telling us that he thinks inflation is too low and long-term interest rates are too high. In a quixotic effort to “maximize employment,” he’s begun purchasing up to $600 billion worth of long-term Treasury obligations to push inflation up and bond yields down.

If it worked as planned, this would flatten the yield curve, meaning it would narrow the spread between short-term and long-term interest rates. Since banks make money by borrowing short and lending long, the effect would be to discourage bank lending. That seems an unpromising way to stimulate the economy. But the whole notion of simultaneously raising inflation and lowering bond yields presumes bond buyers are docile fools.

Indeed. Of course, Reynolds is attacking a straw man.

As I wrote in a previous post, the purpose of quantitative easing is not lower long-term interest rates, but rather to restore monetary equilibrium. (If lowering interest rates was the objective, we would be in big trouble. For heaven’s sake, Chirinko taught us that interest rates aren’t all that important for investment.)

To understand the purpose of QE, let’s consider a simple framework for analysis, the equation of exchange:


where M is money, V is velocity, P is the price level, and Y is output. Re-writing this in terms of growth rates yields:

dM + dV = dP + dY

Suppose for simplicity that we assume that the central bank cannot have any real effects — I’m trying to put a New Classical spin on this. Now suppose that the Federal Reserve has a target for inflation (dP) of 2%. It follows that if inflation is less than 2%, monetary policy should be interpreted as too tight.

Now suppose that monetary policy is too tight and the federal funds rate is at zero. In addition, let’s suppose that M is defined as a broad monetary aggregate like M2 or MZM. With inflation below its target, the Fed wants to become expansionary. Typically, they would conduct an open market purchase of T-bills. However, since T-bills and reserves are essentially perfect substitutes at the moment, this would have no effect other than to increase reserve balances and the monetary base. There would be no effect on the broad monetary aggregate and thus no effect on inflation. In order for the Fed to be successful, they must purchase assets other than the short-term bonds.

In other words, the Fed is trying to increase inflation not for the sake of inflation, but because of the fact that inflation is below its target, which is a signal of monetary disequilibrium.

Reynolds has every right to oppose QE and to dismantle the concept of monetary disequilibrium as a framework for monetary policy analysis. However, to claim that the Fed is only buying long term bonds to lower their yields is simply beating up on a straw man.

3 responses to “Alan Reynolds and the Straw Man

  1. You have read the last Fed mintues or either of Bernanke’s speeches on QE2. They all say very explicitly that the goal is to reduce both nominal and real long-term interest rates. If they had just said we want to raise the growth rate of nominal domestic demand (gross domestic purchases), that would been an honest use of the quantity theory tautology (where “V” is a big fat fudge factor). By measures that include business costs, not simply consumer goods Wal Mart, inflation is not particularly low.

  2. QE2 has already lowered both nominal and real interest rates before it was formally announced. QE2 was almost fully priced in at the time of actual announcement.

  3. Pingback: Blinder on QE2 | The Everyday Economist

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