"QE2" is the wrong response to recent economic softening and, if implemented, is likely to prove counterproductive.
Some QE2 proponents claim that G7 economies are suffering from a shortage of liquidity, evidenced by slow expansion in the broad money supply. (The UK's preferred broad money measure rose by only 1.2% in the year to July, though growth has been faster over the last six months.) An assessment of monetary adequacy, however, must take account of demand as well as supply. Money demand has been depressed by negative real interest rates, which have encouraged a large-scale portfolio shift out of deposits into other assets offering a higher yield and / or inflation protection. Record mutual fund inflows are one reflection of this adjustment.
Put differently, slow money supply expansion is being offset by a rise in the velocity of circulation. Broad money velocity rose by 4.4% in the UK in the year to the second quarter, allowing nominal GDP to expand by 5.9%. When real interest rates were last negative for a sustained period in the 1970s, velocity rose by a cumulative 38.6% over six years, or 5.6% annualised. A similar rate of increase is plausible now, suggesting that broad money expansion of 1-2% per annum is more than sufficient to finance trend economic growth of about 2.5% with 2% inflation.
Rather than inadequate monetary growth, the Federal Reserve this week cited dangerously-low inflation as a reason for considering QE2. The rise of just 0.9% in the consumer price index excluding food and energy over the last year, however, is heavily influenced by a 0.3% fall in "owners' equivalent rent" – a theoretical sum paid by home-owners to themselves. An alternative CPI measure based on the EU's harmonised methodology, which omits imputed rent, rose by 2.1% in the year to July, according to a comparison table produced by the Bureau of Labor Statistics.
There has been no sudden deterioration in inflation news to warrant the Fed's heightened concern. The CPI excluding food and energy increased by an annualised 1.3% in the three months to August, above the 0.9% annual gain. The September University of Michigan consumer survey reported a mean expectation for inflation over the next five years of 3.2%, equal to the average of the last two years.
Some economists support more QE not because they think it is strictly necessary but as an "insurance policy". This wrongly assumes that it would be costless. Additional liquidity, however, might flow into already-overheated financial markets, risking the formation of new bubbles and subsequent disruptive busts.
QE2, indeed, is probably already harming economic prospects by encouraging further speculative buying of food commodities. Recent commodity price gains suggest that G7 CPI food inflation will rise from an annual 0.9% in July to 4-5% – see chart. This would add 0.3-0.4 percentage points to headline CPI inflation, with an equivalent negative impact on consumer purchasing power. As discussed yesterday, the effects will be more serious in emerging economies.
Recoveries proceed in fits and starts and policy-makers should be cautious about attempts at "fine-tuning", which may simply increase volatility. To the extent that policy is constraining economic expansion, proposed tax increases and their impact on confidence are of greater concern than insufficiently loose monetary conditions. In the UK, this argues for postponing or cancelling the planned VAT hike, which will pile more pressure on struggling consumers and may no longer be required given recent deficit improvement – see previous post.
