Additional quantitative easing will, in my view, increase tail risks without necessarily improving the base case macro outlook. On a long view, it continues the pattern of policy making that I think was an important contributing factor to the Great Recession.
The Fed is set to expand quantitative easing. We don’t know important details, which presumably will be settled at the 2-3 November FOMC meeting. We know, however, at least one difference between QE2 and QE1: the motivation. QE1 was an emergency measure introduced amidst deep recession and intense financial crisis. QE2 seems aimed to accelerate an economy that is already growing, and to reduce the deflation tail risk.
We’ll need to see the details to make a firm judgement on the effect of QE2 on the macro base-case. However, Dick Berner expects a flexible approach, but with an initial commitment to buy perhaps US$100bn per month. Dick’s view is that the market has already priced a scenario close to this. More to the point, he thinks the economic impact of this type of monetary stimulus is likely to be quite modest. (See Restarting Asset Purchases: Some Details, 6 October.)
For now, risk assets are running hard on the QE2 prospect. However, I think QE2 will increase important tail risks and ultimately produce other investor-unfriendly side-effects:
First, it increases the risk of disorderly US$ decline. Our FX team expects QE will lead to a weaker US$ (see Ronald Leven, USD: Feelin’ QEasy, 14 October). Orderly decline is acceptable (and presumably an intended side-effect of renewed QE). But it seems unlikely that many other central banks will follow the Fed. In fact, in Europe comments from some ECB members point to a wind-back of the extraordinary liquidity provision. This potentially important divergence in policy could lead to unacceptable dollar weakness for Euro policy makers.