Bernanke felt the need to market QE2 to the public in this Washington Post piece. The basic argument for QE2 we have heard before, which is that the unemployment rate is stubbornly high, and the inflation rate is lower than the Fed would like. Further, Bernanke has some fear of deflation too:
In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.So, apparently he is with Jim Bullard in viewing a deflationary state as potentially absorbing and harmful to real activity.
How does QE work? By moving asset prices:
Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth.Is Bernanke worried about the risks?
Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.Note here that Bernanke is actually paying attention to some monetary quantities, in particular the stock of currency and bank deposits, which is unusual.
Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.
Now, I think it is quite possible that we will look back on QE2 as a severe error. In spite of the talk from some quarters about the intervention being too small, this is a very large-scale asset purchase for the Fed, on top of a previous very large purchase of mortgage-backed securities and agency securities. One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so. Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation.
My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it, and we don't need another problem to deal with.