QE: Prove It First

“Fed itself has admitted in the last couple days in speeches that they don’t know what they’re doing. They just hope what they’re doing works.”

~Kyle Bass of Hayman Capital 10/06/2010 via CNBC

With talk of QE2 in full swing, I found yesterday’s comments from Goldman’s Jan Hatzius regarding NY Fed President William Dudley’s speech very interesting (emphasis is mine):

These are legitimate concerns, but they do not mean QE2 will not have an effect. As President Dudley pointed out, those who are able to borrow will do so at lower rates, freeing up some of the income now being spent on debt service. Perhaps more importantly, QE2 works on other elements of financial conditions, including equity prices and the exchange rate. To the extent these moves bolster consumer confidence, reducing the drive to boost saving, and make US goods more competitive in world markets, QE2 can work through channels other than credit.

Q: What options besides renewed asset purchases does the Fed have?

The main alternatives are to modify its communication with the markets and to tinker with its inflation objectives. Recent speeches by Fed officials have offered some ideas for consideration on both fronts. On communication, he suggested that the FOMC could be more explicit in saying how it planned to respond to shortfalls in meeting its objectives for inflation and unemployment. On tinkering with its inflation objectives (this is our term—decidedly not his!), he suggested that the Fed could, in essence, target the price level over the medium term. Thus, if inflation continued to fall short, then the FOMC would explicitly try to offset that with higher inflation later.

A few things jumped out at me in particular; in addition to lowering borrowing rates the Fed hopes to accomplish via QE2 higher equity prices, a lower exchange rate and avoid deflation with the hope these measures will spur an improvement in the real economy.

Fortunately for us we have a country that has been attempting to spur its economy via these methods for nearly a decade. Let’s take a look at how it has worked.

The first two charts are pulled from a presentation by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Second International Journal of Central Banking  Fall Conference on September 16th of this year.