Surprise! The Case for QE3 Is Stronger Than Ever

Think the economy is too healthy for another round of Bernanke's stimulus? Wrong! In fact, this is the perfect time for more monetary easing. Let me explain...



For the past three years, economists have loved to hate the recovery. But they're coming around to the possibility that they might have to fall in love with the idea that the comeback is real. Typically, a stronger economy means a more conservative Fed. As this chart from Reuters shows, when growth goes up, interest rates go up. (Reminder: Chicago PMI measures business activity in the surrounding area, and the Fed Funds rate is the central bank's benchmark interest rate).


So the spat of good news means we should sit back and quietly expect the Federal Reserve to demur on any more quantitative easing, right?



Take it from none other than a former Fed governor named Ben Bernanke that this situation warrants further monetary easing. In a 2003 speech, then Fed governor Bernanke explained that there are only two factors central bankers should look at to determine whether policy is appropriate: nominal GDP and inflation. (Hat tip to Scott Sumner for the great find). So what does nominal GDP -- which just refers to the total size of the economy -- tell us now? Nothing good.

The graph below shows the difference between where nominal GDP is and where it should be. Over the past 30 years, nominal GDP has grown at a fairly steady rate of 5 percent a year -- until 2008, when we crashed. We haven't made up ground. That's why the current recovery hasn't felt like one. The Fed can and should remedy this, although it looks less likely to do so due to our improving outlook. Which is precisely why now is the opportune moment for more bond buying.


Monetary policy is largely about expectations. If the Fed wants people to spend substantially more, it needs to do something so drastic that it changes what they think will happen to the economy. Christina Romer, Obama's former chief of the Council of Economic Advisers, calls this "regime change." The classic example was the decision to devalue the dollar against gold in the depths of the Great Depression, which set off an immediate mini-boom.

At the risk of sounding tautological, the less something is expected, the more it will change people's expectations. The fact that the markets have discounted QE3 becomes a reason to do QE3. In other words, quantitative easing would change people's attitudes more now than it would if the Fed waits until the economy slows down and markets anticipate it. Another way of thinking about this is asking what message bond buying would send now. The Fed would essentially be saying that even our latest surge in growth isn't good enough, and that the Fed is willing to do more to get the total size of the economy back to where it should be. That would be quite a shift from the previous rounds of quantitative easing, which only came to prevent the worst.

So here's hoping Bernanke can shed his naturally staid, professorial disposition and channel his inner Ashton Kutcher: Please, Mr. Chairman, punk us with QE3.