by Michael Knox

...the mechanism of Quantitative Easing.

When I was a kid, I thought it would be really cool if I could ask Thomas Edison how the light bulb worked. Unfortunately I was born about 60 years too late. Still, earlier this month I went to a presentation by Ben Bernanke at the American Economics’ Association annual convention in Philadelphia. Now because I think Quantitative Easing is the best invention since the light bulb, I had to ask him how he really thought it worked.



This was my question:

“My question is the mechanism by which Quantitative Easing is seen to work: your original statements back in what is called QE1 suggested that what you were doing was targeting higher inflation and avoiding deflation. The impression that that generated was that higher inflation would generate a lower real Fed funds rate and generate more stimulus; but your more recent statements suggest that Quantitative Easing works through reducing interest rates; buying securities which reduce interest rates. Which is the more important mechanism that you are attempting to use here - is it rising inflation or lowering interest rates?”

Bernanke’s answer:

“No, I think you are mixing together goals and mechanisms. The goal was to avoid deflation. So one of our concerns beside the weak recovery at the time of QE2 was that inflation as today, but even more so, was very soft and moving down and we were concerned about deflation risk, and of course, deflation is not a zero one thing, even low inflation can create problems. So we adopted the Quantitative Easing policy with the OBJECTIVE of raising the inflation rate to meet our target, and at the same time, by doing so of course, we would lower real interest rates and help the real economy. So that was the  OBJECTIVE.

The MECHANISM, and of course there is a lot of debate about exactly how this works, and so on, but the mechanism that we have focused on based on sort of a Tobin/Freidman kind of world in which there are imperfect substitutabilities between different assets and so that buying up assets has an effect on the yield of those assets which I discussed today and which I talked about in Jackson Hole right before QE2 as well. So that is the basic mechanism that we have argued.”

What can I say? When Bernanke stopped speaking “the light bulb went on”. The whole of the market and me (before I asked the question) thought that what the Fed is trying to do is increase the money supply. This is why people are scared that QE will drive up inflation. As everybody knows, increasing the money supply increases inflation.

This is not the way the Fed thinks about what they are doing. What they think they are doing is driving up money demand. By buying illiquid assets with highly liquid treasury securities, they are forcing up the price of those illiquid assets and making them easy to trade in volume. They are increasing the demand for those assets.

Increasing the demand for financial assets in this way should and does have the result of driving up national income in dollar terms. In the long run, this increase in national income in dollar terms will have the result of increasing the money supply by increasing bank lending.

Still, in current circumstances you have to wait a long time for this to happen. This is because since the financial crisis, businesses have been scared to borrow and banks have been scared to lend. This means that the increase in money supply is both smaller and slower than you would expect from such an increase in money demand. The fact that the increase in money supply is so much slower and lower is why everybody was wrong when they were scared that QE would be inflationary.

The fact that the Fed is intentionally driving up money demand and the demand for financial assets of course explains why financial markets have been so strong. So maybe I was right. Maybe Quantitative Easing is the best invention since the light bulb.