What Is the Fed Waiting For?

In a new FT column I discuss some of the arguments for and against additional monetary stimulus. On balance, I'm for it--and I wouldn't bet against it happening in the next month or two. The August 9th FOMC minutes released today confirm what we already knew: since QE2 ended in June, the Fed has learned that the recovery is slower and more fragile than it previously thought, and that inflationary pressures have eased. There you have it: what else does the Fed need to know before it embarks on QE3?

The promise that interest rates will stay low for two years--at least, that is how the Fed's earlier statement was widely reported--is a weak holding action at best, once you realize that this "promise" is actually no such thing. As the original post-FOMC statement said:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

That is not a promise to keep rates low regardless (which would change expectations and thus impart some additional stimulus): it is a tentative prediction that the recovery will be slow, and if it is then rates will need to stay low. Well, obviously. Had investors previously believed that the Fed would raise interest rates before conditions allowed? The minutes say:

One member expressed concern that the use of a specific date in the forward guidance would be seen by the public as an unconditional commitment, and it could undermine Committee credibility if a change in timing subsequently became appropriate. Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.

That "one member" was correct. Most commentators did take the so-called conditional guidance as an unconditional commitment. (On the other hand, if the public had not done so, the guidance would have conveyed nothing and been pointless.)

A correspondent asked me to explain what I meant in the column when I said that extra caution in the use of QE would be justified if the recession had damaged long-term growth prospects. The point is that QE raises aggregate demand--and how much demand can be increased without causing inflation depends on how much spare capacity the economy has. This in turn depends on whether the recession has permanently undermined the supply side of the economy. The Fed's position is that, so far, there has been no permanent damage. Therefore, it ought to conclude, QE3 makes sense. In fact, it makes all the more sense if you believe--as the Fed does (see Bernanke's Jackson Hole speech)--that the subpar recovery will undermine the supply side if it is allowed to persist.