Commentary - They Just Don’t Get ItLocation: Chicago Chart 1 Chart 2 Another Fed rationalization for embarking on QE2 was to raise inflation expectations. Why in the world would an independent central bank want to raise inflation expectations? Isn’t the whole idea of central bank independence to contain inflation? Well, again, economists are hung up on the “real” rate of interest – that is, the observable nominal interest rate minus the unobservable investor inflation expectations. That real rates of interest influence economic decisions has a lot more theoretical basis than does the notion that nominal bond yields do. But even though there is more theoretical underpinning for real rates than nominal rates, there is little empirical support. After all, if real interest rates were such a good predictor of future economic activity, why is there not a real interest rate in the Conference Board’s index of Leading Economic Indicators? The folks who put this index together are guided by what “works,” not by theoretical purity. One reason that I believe that the empirical support for a real rate of interest as a leading indicator is lacking, aside from difficulties in directly measuring inflation expectations, is that equilibrium real rate of interest is always changing, just as the equilibrium price of copper changes from day to day due to changes in supply and demand. When the levels of interest rates are low and especially when the levels of short-maturity interest rates are approaching zero, which they are now, because nominal interest rates cannot move into negative territory, the only way to get real interest rates lower is to raise investors’ inflation expectations. The Fed appears to have made some progress in this area even before purchasing its first security of the $600 billion tranche. In recent weeks, the yield on the Treasury Inflation-Protected 5-year security has moved into negative territory and the yield on the Treasury Inflation-Protected 10-year security has fallen (see Chart 3). The yields on these inflation-protected securities are proxies for real interest rates. So, if lower real interest rates are the goal of QE2, then “mission accomplished.” Chart 3 But I do not believe that bringing down nominal interest rates, real interest rates, the foreign-exchange value of the dollar and/or raising the value of U.S. equities is what QE2 is, or should be about. I think that if the Fed desires a quicker pace of nominal GDP growth, the goal of QE2 should be to increase the quantity of the sum of Federal Reserve and commercial banking system credit. After all, why is it called quantitative easing if it does not involve quantities? The Federal Reserve has the unique ability to be able to create credit figuratively “out of thin air.” So does the commercial banking system, if the Fed provides the “seed money.” The ability to create credit out of thin air implies that the recipients of that credit can increase their current spending without any other entity in the economy having to cut back on its current spending. Chart 4 shows that combined Federal Reserve and commercial banking system credit have recently contracted at an unprecedented rate. The rate of contraction is slowing. The goal of QE2 should be to get this credit aggregate growing. If $600 billion of securities purchases by the Fed does not result in growth in this credit aggregate, then the Fed could increase the quantity of its securities purchases. Milton Friedman passed away only a short time ago, in 2006. It seems that much of his wisdom about the importance of quantities rather than prices (that is, interest rates) with regard to monetary policy passed with him. Chart 4 Paul Kasriel is the recipient of the 2006 Lawrence R. Klein Award for Blue Chip Forecasting Accuracy The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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