Some Further Thoughts on "QE2"

Those who believe that the economy needs more stimulus are worried because the likelihood of it coming from fiscal policy in the near-term seems unlikely. Laurence Myer in his presentation this weekend said that, since the Fed has reached its lower bound of zero on the fed funds rate, it is time for fiscal stimulus. That, though, seems politically impossible. He went on to say that, if the Fed wants to lower longer-term Treasury yields, it can either choose a quantity of Treasury notes and bonds to buy or target a specific yield for Treasury 10-year rates. The second option is more risky for the Fed; it loses control of its balance sheet because it does not know the amount of securities it needs to buy in order to hit its target.

Also, I would note that, as the Fed buys massive amounts of Treasury notes and bonds, market participants may worry about future inflation. In other words, while the Fed may reduce the supply of Treasury notes and bonds, demand for them may also fall. The Fed will not likely want to end up owning all the Treasury 10-year notes. If it did, what would be the price of private debt obligations in the absence of a Treasury reference yield?

An alternative, of course, is for the Fed to buy private securities in order to reduce the spread between them and Treasuries, but this also raises issues, such as selection and potential charges of favoritism. It would also contribute to the decline in the quality of the assets the Fed holds.

Mr. Myer concluded that, if the Fed's policy of increasing its balance sheet does not work and unemployment continues to rise, there will be fiscal stimulus. It would be different than the first stimulus, since Republicans more partial to tax cuts will have more say. He suggested one possibility might be a payroll tax holiday.

I agree that, if the unemployment rate increases, additional fiscal stimulus will ultimately be undertaken. Whatever their ideologies or economic beliefs (Ricardian equivalence?), politicians will heed the calls for the government to do something if the economy worsens.

I was somewhat surprised at the pessimism I heard from the people in the financial sector who descended on Washington last week and were here through the weekend. The possibility of a slow recovery seems to be discounted, but that may be what happens. One reason for the pessimism of this international crowd is  the specter of currency wars, and that is indeed worrying.

Another reason to worry, but the international bankers seemed less focused on it, is the U.S. foreclosure crisis. There has been an amazing disregard for the importance of state laws governing transferring of ownership of real estate in the securitization of mortgages. How this will be resolved is at this point uncertain, but financial intermediaries are likely to be hurt.

In any case, Keynes' "animal spirits" were hard to find among the international financial sector representatives in Washington last week. Will a new dose of quantitative easing fix that or cause more anxiety?