There have been a number of recent contributions making the case for QE3 in the United States following weak employment and GDP numbers. Recent market reactions to Bernanke's efforts to distance the Fed from a further round of quantitative easing prompted a sharp reversal in financial markets this week, suggesting investors had priced in a further round of asset purchases under QE3. Central bank communications indicate that the prospects for a QE3 announcement this year are now remote -- the recent Bernanke intervention aligns the Federal Reserve with the Bank of England, whose Monetary Policy Committee includes just one active proponent of further quantitative easing.
Are policy-makers right to pause the unconventional monetary policy started in 2009? At present the main source of macroeconomic weakness in countries such as the US and the UK is the lack of domestic demand as resources are devoted to post-crisis balance sheet repair. A key objective for macroeconomic policy is to stimulate employment and investment by small and medium-sized companies, which requires higher consumer spending by households. Quantitative easing is certainly capable of achieving this but is far from the most effective tool available. QE essentially involves liquidity creation intended to leave the private sector long in low yield/low risk assets. Portfolio rebalancing in the aftermath of liquidity injections then stimulates asset prices, spending patterns and economic activity. But the main beneficiaries tend to be large corporations whose financing costs fall as the search for yield spreads to their corporate debt and equity. Hence, the main channel through which QE propagates to the real economy is through boosting corporate profitability and enhancing the prospects for investment and job creation. In contrast, for individual households and small firms the benefits from QE are less direct. If asset purchases take the form of mortgage backed securities rather than Treasuries then lending to homeowners may increase, but whether such financing finds its way to households whose budgets are under most pressure is unclear, and in any case the recent trend, in QE2, has been for the Fed to bias its purchases towards Treasuries rather than more risky assets. Alternatively, QE may prompt investors to purchase foreign assets and weaken the currency in a way that supports exporters, but whilst small firms will benefit from this, the main effect will be felt amongst large firms, and consumers' purchasing power tends to be undermined by currency depreciation.
What are the implications for the QE3 debate? If the main objective of macroeconomic policy is to ease the pressure on household and small firm budgets, improve sentiment and correct a source of weakness in demand, further rounds of QE are unlikely the best way forward, at least not in isolation. The priorities should be keeping interest rates at low levels for an extended period, to contain debt service costs for households and small firms, and directing temporary tax breaks at low income households and small firms. This of course would require some reduction in the pace of government budget deficit reduction in the short-term, and here QE could play a role in that additional central bank purchases of government debt would help to restrict government financing costs as borrowing increases in order to provide cuts in small business corporation tax, employer national insurance contributions and basic rate income tax.
In short, if the case for QE3 is to be evaluated through asking whether it is the most appropriate macro policy measure to support economic recovery, there are reasons to think the case is weak, and that any role for QE3 and similar policies in other countries, must be in conjunction with changes to the structure and overall stance of fiscal policy.