Here’s Why The Fed Believes QE2 Is Necessary

Monday’s NYSSA luncheon with St. Louis Fed President (and voting member of the FOMC) James Bullard was most illuminating (wish you were there). In addition to the somewhat heated give and take with attendees, Mr. Bullard provided a chart that captures the principal fear the Fed has re deflation. It is what is known as the steady state (equilibrium) of inflation and interest rates.

The accompanying chart is the one he presented (which was also provided in his recent commentary and presentation “Seven Faces of “The Peril’”). In it I have pointed (larger arrows) to the steady state for the US (boxes to the right), steady state for Japan (circles to the left), and in the middle the May 2010 current level for the US. You will note that the May 2010 point is the closest to the Japan outcomes.

The concern at the Fed is that the slide toward the steady state for inflation and interest rates (in a zero bound interest rate environment) renders interest rate driven monetary policy impotent (as it has in the case of Japan). Moreover, a steady state tends to become entrenched (that’s why it’s called a steady state). And economists will tell you that when it comes to deflation/inflation it is the entrenched, longer term levels (and not the shorter term, more volatile factors such as commodities) that matter most.

As the May 2010 point illustrates quite clearly, the US trend is not where the Fed wants it to be.

Here’s Why The Fed Believes QE2 Will Work

In a nutshell – because it worked the first time.

Time and again in the aforementioned heated discussions, Mr. Bullard consistently pointed to the financial markets rebound during QE1 and in anticipation of QE2 as evidence of the positive effects of QE. Moreover, since the economy has recovered and avoided further economic deterioration (Great Recession not Great Depression 2), QE was and will be (in his opinion) effective.

Conclusion

No doubt the debate over the Fed's QE policy will continue. But at least now you know some of thinking behind the actions.

Caveat: Mr. Bullard was speaking for himself and his opinions do not necessarily reflect those of the Fed.
Click image to enlarge