QE3: three possible outcomes.

How to Think about QE3

By Arnold Kling

Alan Blinder, a prominent Democratic economist, once complained that when economists are in broad agreement with high confidence (on the issue of free trade, for example), they are never consulted. Instead, journalists and laymen ask economists to make pronouncements only on topics where there is little confidence and strong disagreement.

Recently, I have encountered this “Murphy's Law of economic advice” in the form of people asking me what I think of QE3, which is the name given to the Federal Reserve's latest initiative to stimulate the economy by purchasing long-term debt instruments, including mortgage-backed securities. (“QE” stands for “quantitative easing,” and the “3” refers to the fact that this is the third such initiative undertaken by the Fed since the financial crisis sent the economy into recession.)

When it comes to QE3, while there is no solid professional consensus on which to draw, I can boil the issue down to two questions. 

1. First, will QE3 raise inflation? That is, will inflation be higher than it would have been without QE3?
2. Second, will the inflation-unemployment tradeoff be favorable? That is, will we get a large gain in employment with relatively little pain in terms of higher inflation? Or will we get a lot of pain for little or no gain?

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Three Scenarios

Overall, the possible outcomes are as follows:

1. If QE3 operates like sterilized intervention, we will see some short-term reductions in the cost of certain types of long-term borrowing, but these effects will soon dissipate. In the end, the economy will proceed along the same path as it would have without QE3. I put the probability of this at 20 percent.

2. If QE3 operates like unsterilized intervention or like sterilized intervention with a credibility kicker, and the Phillipsians are correct, then QE3 will put us on a slightly higher inflationary path with significantly lower unemployment. I put the probability of this at 30 percent.

3. If QE3 operates like unsterilized intervention or like sterilized intervention with a credibility kicker, but the Phillipsians are incorrect, then QE3 will put us on a significantly higher inflationary path with little effect on unemployment. I put the probability of this at 50 percent.

Unfortunately, assessing the actual result will be difficult, even after the fact. It will be tempting to compare the state of the macroeconomy 12 to 18 months from now with the state of the economy today. However, the relevant comparison is between the state of the economy 12 to 18 months from now and what it would have been without QE3. This is not an experiment that we are capable of running.

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