The U.S. economy continues to struggle and yet the Federal Reserve remains on the sidelines despite having the ability to do more. In “What’s The Holdup With QE3?” James Bianco tackles the question I have been asking myself for months.
Bianco’s theory is that the Federal Reserve only loosens monetary policy when expectations of inflation, as measured by the 10-year TIPS break even rate, fall below 2 per cent. When examining the data that Bianco provides, it is a convincing argument, as QE1, QE2 and Operation Twist were all enacted when the TIPS spread fell below 2 per cent, but no actions were taken when the spread was at or above 2 per cent.
It is the best explanation of the Federal Reserve’s thinking I have seen to date. I hope, however, that Bianco is incorrect.
Such a strategy is in clear violation of the Federal Reserve’s own mandate. First, there is no reason why such a long period should be considered. The Federal Reserve’s monetary policy role is to smooth out deviations in the business cycle. Unless there is a belief that this slump will last another decade, a shorter term (18-36 months) outlook is more appropriate. The Cleveland Fed’s measure of inflation expectations show inflation nowhere near a 2 per cent level over the next three years.
Second, and more importantly, is that the Federal Reserve has a dual mandate of both 2 per cent inflation and keeping the United States at full-employment, which it estimates to be between 5.2 and 6 per cent. When the two objectives are in conflict, the Federal Reserve must “under circumstances in which the Committee judges that the objectives are not complementary, [follow] a balanced approach.”
With a U.S. unemployment rate at 8.3 per cent – well above its target – the Fed is required to balance inflation and unemployment. They do so by having inflation, and inflation expectations, significantly above 2 per cent.
I hope we do not live in a world where the Federal Reserve is willfully ignoring its own mandate. But from the evidence James Bianco provides I can reach no other conclusion.
Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University
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