“Inflation is always and everywhere a monetary phenomenon.”
The first round of quantitative easing occurred in 2008 and 2009 in response to the financial crisis as the Fed purchased approximately $1.25 trillion in securities from Fannie Mae and Freddie Mac. On November 3, 2010, the Federal Reserve announced a second round of quantitative easing (or “QE2”) through which the Fed will purchase $600 billion of U.S. Treasury securities. In the cases of both the 2000 dot-com market crash and the 2001 terrorist attacks, monetary easing of this sort was withdrawn relatively quickly. However, concern is growing as to how and when the Fed will withdraw the massive balance sheet expansion of the past two years to contain long-term inflation and protect the value of the dollar.
Experimenting with Short-term Actions Risks Long-term Failure
A Dueling Mandate: QE2 is intended to keep interest rates low. The proximate justification for maintaining interest rates at low levels is that the nation’s high rate of unemployment compels the Fed to try to stimulate economic activity under its “dual mandate” to support full-employment output and price stability. However, this policy approach risks eroding the long-term value of the dollar and undervalues the economic impact of rising commodity prices denominated in dollars, as the prices of items such as food and gasoline increase steadily. Moreover, many credit an excessively low interest rate environment with leading to financial market weakness vis-à-vis global credit misallocations in the first half of this decade, which precipitated the 2007-2008 financial crisis.
Exporting Inflation: A side effect of expanding the global supply of dollars is a depreciating exchange rate relative to currencies of our trade partners. To that point, Nobel economist Joseph Stiglitz warned in a recent Wall Street Journal op-ed:
"Lower interest rates may also lead to a weaker dollar, and the weaker dollar to more exports. Competitive devaluation engineered through low interest rates has become the preferred form of beggar-thy-neighbor policies in the 21st century. But this policy only works if other countries don't respond. They will and have…[t]hey too can lower interest rates. They can impose capital controls, taxes and bank regulations, and they can intervene directly in their exchange rate…
"The upside of QE is limited. The money simply won't go to where it's needed, and the wealth effects are too small. The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export."
With globalized supply chains, increased input costs of products manufactured in various countries around the world will ultimately result in higher prices for consumers whether in the U.S. or abroad.
A Weak Dollar Does Not Beget Strong Growth: In the absence of pro-growth fiscal policy—tax reform, spending cuts, and regulatory overhaul—QE2 will do more harm than good. Increasing the supply of dollars or credit in excess of the economy’s demand reduces the expected future value of the currency—a precondition of inflation. With no explicit plan for when or how this quantitative easing will be withdrawn, the Federal Reserve could do more for the American economy by focusing singularly on maintaining the value of the dollar and protecting the purchasing power of Americans.