SLI View: Does the US need QE3?

Douglas Roberts, senior international economist at Standard Life Investments, discusses whether the US needs a third round of quantitative easing.

While the programme of US bond purchases, affectionately known as QE2, has yet to be completed, there are already calls in America for a new initiative (presumably to be known as QE3) to be introduced. QE is dead, long live QE! However, isn’t it a tad paradoxical that the apparent failure of QE2 should bring calls for more of the same? Einstein’s definition of insanity was doing the same thing over and over again, expecting a different result.

It seems highly reasonable that, before embarking on another round of spending, there should be an appraisal of how far the present programme met its objectives. Are there grounds for believing that sufficient progress has been made to warrant a supplementary commitment? Fortunately, the President of the Federal Reserve Board, Ben Bernanke, set out clearly at its launch how he anticipated that QE2 would improve the state of the economy.

The Fed, unlike some other Central Banks, has a dual mandate of delivering both price stability and economic growth. Towards the end of 2010 there were good grounds for suspecting the Fed could miss out on both. Inflation was hovering around 1%, with a fear that deflation could easily be a risk, while the economy was struggling to achieve escape velocity into self-sustained growth. Until the economy achieves the latter, it is likely to require periodic help from the government.

On the Fed’s own model, economic growth needs to exceed 3% a year to absorb additions to the labour force. It was failing to achieve this on a consistent basis. In these circumstances Mr Bernanke justified another round of bond purchases. The judgement was that, although it had not delivered a marked improvement in the economy, equally it had not made matters worse. So another round of liquidity injection was agreed upon, although not unanimously.

The launch of QE2

Mr Bernanke, in a Washington Post article, set out his stall about how he expected QE2 to bring about improvements to the working of the economy:

• He expected that ‘easier financial conditions would promote growth’
• He believed that ‘lower mortgage rates would make housing more affordable, and allow more homeowners to refinance’
• Higher stock prices would boost consumer wealth, and help increase confidence, which can also spur spending. Increased spending would lead to higher incomes and projects that, in a virtuous circle, would further support economic expansion.

Let’s appraise each of these objectives.

1. Easier financial conditions

The structural flaw was that, even if the initiative had delivered ‘easier financial conditions’, the transmission mechanism was still dysfunctional. Borrowers, both households and corporates, were more intent on deleveraging than taking on more risk, while lenders were busy re-capitalising rather than growing their loan book.

It is true the senior loan officers have not been tightening incrementally over recent months but, equally neither have they been aggressively loosening the terms and conditions at which they are prepared to do business. Individual credit growth has increased over the past six months, but it has more reflected a pick up in student loans than credit card credit growth. Corporate borrowing, too, has been fitful and concentrated more on financial sector borrowing.

So on the first claim for QE2, the appraisal must be that it failed to deliver. Economic growth in the first half of 2011 looks to be coming in at an annualised rate of around 2.0%, well below the level that would generate self-sustaining growth. It has been argued that monetary stimulus is likely to be ineffective in a balance sheet recession – one in which deleveraging is the driving force. This seems to be the case.