QE2

I have been reading a lot of nonsense about the effects of the Fed's policy of quantitative easing (QE2). Here is my e-mail response to a friend who asked me about this:

Catherine:

I think Bernanke did exactly the right thing when he pushed the Fed into QE2. Moreover, at least so far, QE2 is a success. How do I know? First, the dollar index is going down (and I think it has a good shot at 65 - but when QE stops the dollar will rally, and rally big time). Second, the yield on the US 10 year is going up while the tips spreads are pretty much unchanged. This shows the bond market is expecting more economic growth, not more inflation. Third, the US stock market is going up, also reflecting expectations of higher growth.

QE works by inflating asset prices (stocks, commodities, real estate and other real assets) which rise initially because investors re-balance their portfolios after they sell assets to the Fed. But rising asset prices encourage their production (real investment) and also make people more optimistic about the future (more bullish "animal spirits" to borrow Keynes' phrase). These last two effects boost economic growth if there is slack in the economy as there is now.

Carl