If the Federal Reserve begins another round of asset purchases in November, as widely expected, how much money should it print? Is $100 billion enough? Is $1 trillion too much? Considering that the U.S. is in a time of great economic uncertainty, it's very hard to tell what the right size would be. For that reason, the more flexibility the Fed has, the better. That's why an open-ended purchase plan makes so much sense.
Federal Reserve Bank of St. Louis President James Bullard suggested such a plan on Thursday. Matthew Brown and Wes Goodman of Bloomberg report on his proposal:
"If we do decide to go ahead with quantitative easing, I think there is a good program we could adopt, one I like, which is to think in units of $100 billion between meetings" of the Federal Open Market Committee, Bullard said at a conference hosted by the district bank. "We could give forward guidance for the next meeting that would suggest how likely the committee thinks we would continue these purchases."
Let's start with the criticisms of such a plan compared to one where some large sum is instead announced for purchases to take place over some time period. There are two that stand out.
The first is that the market might not like it. Investors and traders instead may prefer more certainty about how money supply the Fed will add to the financial system. But according to that same Bloomberg article, the Treasury market responded positively when it got wind of Bullard's plan, rallying to a weekly gain. So the market's reaction to an open-ended plan might not be an issue.
The second concern is that it might not have as great of an effect as a shock and awe campaign where the Fed drops a giant bag of money on the Treasury market. If you slowly drip water on a fire, it isn't as likely to be extinguished as if you dump a pail of water on it.
If the Fed was certain that a large asset purchase plan, in the order of $1 trillion to $2 trillion was right for the economy, then this second criticism would be stronger. Central bankers have no such certainty, however. In fact, most economists agree that the U.S. is in a slow recovery. This intervention is merely meant to strengthen it and prevent prices from slipping into a deflationary period. As a result, dropping a money bomb on the market could do as much harm as good. If the Fed overcorrects, then another credit bubble and undesirably high inflation could result.
For that reason, flexibility is prudent here. Let's say the Fed announces $100 billion in purchases in November. Employment growth continues to be anemic and inflation continues to head towards zero in the months that follow. Then the Fed can announce another $200 billion in January or March. It will leave the door open for more purchases, which the market can come to expect if these key indicators don't improve.
But what if the opposite happens? What if the Fed announces $100 billion and the labor market suddenly starts growing at a much healthier pace and prices suddenly begin rising? In that case, the Fed can close the door as long as the trend continues in a positive direction.
Given the volatility and uncertainty that still plague the U.S. economy, it would be unwise for the Fed to expand monetary policy without providing itself ample flexibility to change direction. For that reason, an open-ended program would make the most sense.
We want to hear what you think about this article. Submit a letter to the editor or write to email@example.com.