QE3: The Fed's New Stimulus Is a Monster, but How Will It Help the Economy?

Ladies and gentlemen, we're all about to learn the value of a Ben Bernanke promise

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Ben Bernanke has a message for Washington. The recovery doesn't deserve its name. You're not doing your job to fix it. Now it's my turn.

To be fair, it's been his turn for a long time. The Federal Reserve has a dual mandate to keep both inflation and unemployment low. But unemployment hasn't fallen under 8% in Obama's term and inflation is nowhere to be seen. And so, two years after announcing a second round of quantitative easing, or QE, to help the economy, the Fed chair did something really, truly big.

He announced stimulus without limit.

The best way to understand the move is to think of QE as medicine. In 2010, Bernanke handed the economy a short-term order of pills. In 2012, he offered an unlimited prescription. Two years ago, he pledged quantitative easing with the hope that unemployment would improve. In 2012, he promised to buy bonds "until such time" as unemployment and the economy improve "substantially."

"Even when the unemployment rate begins to come down decisively, we're not going to rush to remove policy," Bernanke said at a press conference later today. "We're going to give it time."


Quantitative easing is a horrible term in service of a necessary goal. It is economic stimulus. It's not like the famous stimulus passed in Obama's first month, which cut taxes and raised spending by more than $800 billion. Instead, the Federal Reserve lowers interest rates and buy debt from investors to encourage them to lend more money.

My favorite way to understand the purpose of quantitative easing comes from an extended metaphor from Chris Hayes. Imagine the economy as an irrigated farm with the Fed as the farmer in charge of the spigot and the water and the pipes. When things are growing, the Fed must be careful to not drown us with too much money. But when the things are dry, as they are now, it's the Fed's responsibility to return the farm to growth.

For the last four years, the Fed has tried almost everything to irrigate the economy. By lowering interest rates, it kept money flowing between the banks. By buying debt from investors, it scraped the gunk off the pipes, increasing liquidity and encouraging more lending, more spending, more hiring. But unemployment is still over 8% and growth is still slow. Why?

One explanation is that the Fed has failed from lack of creativity and will. Most of the economists I read think the central bank should announce a higher inflation target to super-charge spending and investment. They might be right. But the other thing to remember is that, like any farmer, the Fed doesn't control all the variables for growth. High household debt, a weak global economy, and awful residential investment are all contributing to our economic drought.

The Federal Reserve doesn't have explicit answers for these problems. Unlike Congress, it cannot send checks to families in the mail to raise income, or increase spending for defense contractors to raise employment. Instead, its policies can change expectations to encourage families and businesses to invest with confidence. By raising inflation expectations, QE can give the stock market a boost, and by lowering long-term interest rates it can encourage families to buy houses.

You might say that a frothy stock market isn't exactly the most efficient way to help a lower-income family that's never thought about stocks in their life. But, as I've written, a rising stock market isn't just good news for large companies and investors. It can also help overall consumer spending.

In an impassioned defense of QE2, economist Martin Feldstein noted that the economy's strong rally at the end of 2010 was driven by a sharp increase in real personal spending, which in turn was driven by a decline in the savings rate and a sharp increase in the stock market. "There is no proof that QE2 led to the stock-market rise, or that the stock-market rise caused the increase in consumer spending," Feldstein admitted, "but the timing of the stock-market rise, and the lack of any other reason for a sharp rise in consumer spending, makes that chain of events look very plausible."


Two weeks ago, Michael Woodford, a monetary economist, presented a very celebrated and wonky paper making a simple point.  The Federal Reserve's greatest power isn't the ability to buy bonds. It's the ability to make promises.

In a world where the Fed makes stimulus contingent on bad economic news, it creates a start-stop psychology for businesses. When a jobs report is bad, people expect more QE. But when a jobs report is good, people expect less QE. That's weird! In an ironic way, it makes good economic reports bad for the long-term economy because it makes the Fed less likely to offer further support.

Today's announcement changes that. Bernanke essentially said: I'm going to keep my foot on the gas even after the economy starts to recover. Good economic reports or bad, the Federal Reserve will be working to keep interest rates low "for a considerable time after the economic recovery strengthens." We don't know what impact this will have on the housing and jobs market. But we're all about to learn the value of a Ben Bernanke promise.