Hidden behind the election coverage is the likelihood that the Federal Reserve will shortly begin a round of monetary stimulus.  The tool they are likely to use goes by the unfortunate moniker of ‘quantitative easing’ or – for the acronym lovers out there – QE.  It’s worth trying to understand what the Fed is trying to do and what is making them begin a new round of stimulus.

Federal legislation dating from the Truman administration compels the Fed to try to achieve the lowest possible levels of unemployment and inflation.  Unfortunately, minimizing both (like the legislation suggests) is not possible.  Congress seems to forget it cannot repeal the laws of economics.  So, in the short run, the Fed can conceivably boost employment by flooding the economy with money, but the longer run cost of this is inflation.  Experience suggests that even a modest period of money growth and low unemployment can lead to dreaded stagflation – or high unemployment and inflation.  So, why would the Fed risk that now that we have seen employment growth, albeit quite sluggish for the better part of a year?  There are two reasons.

First, the new job growth is insufficient to shrink the numbers of unemployed.  While this experience is a replay of the 1992 and 2002 ‘jobless recoveries’ most big recessions are followed by big recoveries.  Not this one.  Second, the signs of inflation remain tantalizingly distant.  This has come as a broad surprise to economists given the astonishingly dramatic increase in Federal debt and monetary stimulus from 2008 through the present.  So, the Fed is concerned that the absence of inflation marks the hidden presence of other problems in the economy.  I think they are mostly right, but a vocal and growing element of the Fed’s decision making board disagrees with the use of QE. 

The QE that is about to occur is pretty simple.  The Fed simply creates money on its balance sheet and buys bonds from banks.  This increases the excess holdings within banks, and thus incentives them to lend more money.  This should boost the economy.  The problem is that the resistance of banks to lending is not a monetary problem. Banks already have plenty of money to lend, but they have new weighty regulatory burdens on lending.  Likewise they are bereft of trained loan officers, having downsized those operations since the early 1990’s.  Most importantly, the best borrowers are waiting until some economic uncertainty is removed (perhaps by last week’s election). In short, QE cannot be a panacea until the impediments at the local banks and businesses are fixed. 

There are dangers to QE. Some analysts believe that QE will lead to a weaker dollar as banks simply hold other assets rather than lending. Some suggest a 20% decline in the dollar’s value against other currencies. While that might help exporters, my quick statistical model tells me that one result will be a 15 cent per gallon increase in the price of gas. This is a tough time for the Fed.