Despite hopes that the anti-QE rhetoric would die down, the noise continued last week, and unfortunately, become more political. One of the key aspects of the Fed is its independence. The Fed is answerable to Congress, and ultimately, to the American people. However, it is not controlled by Congress – nor would we want it to be controlled by Congress. Attacks on the Fed and its latest round of asset purchases aren’t helping.

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Weekly Commentary by Dr. Scott Brown
The Fed Under Attack
November 22 – December 3, 2010
Despite hopes that the anti-QE rhetoric would die down, the noise continued last week, and unfortunately,
become more political. One of the key aspects of the Fed is its independence. The Fed is answerable to
Congress, and ultimately, to the American people. However, it is not controlled by Congress – nor would
we want it to be controlled by Congress. Attacks on the Fed and its latest round of asset purchases aren’t
helping.
The Fed has a dual mandate: price stability and maximum sustainable employment. While one can
imagine that these two goals might conflict from time to time, they don’t over the long term. The
conventional wisdom, backed by empirical research over the years, is that economic growth and
employment will be better over time if inflation is held low. The unemployment rate has been running
steady at about 9.6%, but that understates the degree of weakness in the labor market (as discouraged
workers drop out of the labor force and more people can only find part-time work). Adding these back
into the mix, the broad measure of unemployment, the U-6, is a little over 17%. Moreover, the economic
outlook is for moderate growth over the next several quarters – not enough to push the unemployment
rate down by much. The Fed is failing on its low unemployment mandate.

2. The persistence of excess capacity in the economy puts downward pressure on inflation. Ex-food &
energy, the Consumer Price Index rose 0.6% in the 12 months ending in October, a record low. The Fed’s
stated goal of price stability does not mean 0% inflation. Rather, The Fed’s implicit goal for inflation is
around 2%. One reason for that is so that the Fed has room to maneuver interest rates if the economy
slows. It’s real interest rates that matter for the economy, and lower inflation implies (all else equal)
higher real rates, which dampen the pace of growth. The economic outlook suggests that inflation is likely
to continue to trend low for the next several quarters. The Fed is failing on its mandate for price stability.
There will be some proposals in 2011 to shift the Fed’s focus to a single mandate: price stability. This is
nothing new. It happens every year. The proposed legislation usually dies a well-deserved death in
committee. Most central banks around the world have a signal mandate: an explicit target for inflation.
That works for them. The Fed’s inflation goal is implicit – there is no formal mechanism – but as
previously mentioned, the prevailing view is that the Fed’s two goals are really one.
Last week, a group of Republican-leaning economists, historians, and others – none an expert on
monetary policy (with the exceptions of Stanford’s John Taylor, which is odd) – sent an open letter to Fed
Chairman Bernanke requesting that the Fed discontinue its asset purchase program. More unsettling,
Republican leaders in the House and Senate sent a letter to Bernanke expressing their “deep concerns”
about the Fed’s quantitative easing program. Ironically, the letter started by expressing the belief that

3. “monetary policy decisions by the Federal Reserve must be free and independent of political pressures.”
The authors then proceeded to apply political pressure. Really, you can’t make this kind of stuff up.
Fed officials, including Chairman Bernanke, have done a good job of explaining the decision behind the
Fed’s asset purchases, but the message has been drowned out by the noise. I’ve been doing this for more
than 25 years and I have never heard the Fed being criticized as much they are now. Certainly, there are
legitimate debates regarding the Fed’s quantitative easing program. Not every critic is ill-informed.
However, most of what’s out there is just rhetorical noise. Many of the Fed’s critics warned that the first
round of QE would generate runaway inflation by now. Instead, core inflation is at a record low. Again,
you can’t make this kind of stuff up.
The Fed is not doing well in the court of public opinion. It needs to do a better job of PR if it is to avoid
well-intentioned, but ill-advised Congressional reforms in 2011.
Lighten Up, Francis
November 15 – November 19, 2010
To hear tell it, government spending is “out of control,” the Fed is pursuing “reckless” policies that will
fuel hyperinflation, and the dollar is “worthless.” Get a grip, people.
The exchange rate of the dollar is a price, which is determined by supply and demand. The foreign
exchange market is huge. The Bank for International Settlements estimates average daily turnover of
about $4 trillion (including foreign exchange swaps, spot transactions, outright forwards, etc.), but what
matters for the exchange rate is net transactions. The U.S. has a net current account deficit (which is
mostly the trade deficit) and a net capital surplus. These two will balance naturally and the dollar is the
equilibrating factor. That is, if the net capital surplus is less than the net current account deficit, the dollar
will fall, reducing the current account deficit. The current account deficit hit 6.5% of GDP in 4Q05, fell
sharply in the recession (to 2.4% of GDP in 2Q09) and is widening again (3.4% of GDP in 2Q10). Recent
data suggest that the trade deficit may be stabilizing.
Note that the long-term trend in the dollar is moderately lower, with the exception of two periods (the
early 1980s and around the turn of the century) where the dollar rallied then reversed. Both of these dollar
spikes were associated with a widening trade deficit. Did people freak out when the dollar slid in the late

4. 1980s or in the last decade? Some probably did – but the outcry wasn’t near as deafening as it is now. Go
figure.
There are a number of forces at work on the dollar. The current account deficit has long-term implications
(somewhat negative). In the intermediate term, growth differentials appear to matter. The U.S. economy
is likely to outperform Europe over the next two to four years. So, the dollar should hold up well against
the euro and the pound. On the other hand, emerging economies should grow more rapidly than the U.S.,
putting downward pressure on the dollar relative to East Asia – and the Chinese currency, in particular.
Canada is seen as “a commodity country.” Higher commodity prices imply a stronger Canadian dollar,
but Canada also exports a lot of manufactured goods to the U.S. All else equal, a stronger Canadian dollar
will dampen exports to the U.S., slowing the Canadian economy and, in turn, weakening the currency. So,
we can expect some volatility in the loonie as it searches for an equilibrium. Short term, central bank
policies matter. All else equal, easier Fed policy implies a somewhat softer dollar and somewhat higher
commodity prices in the near term.
Interestingly, some of the same people that complain about the dollar also complain about the trade
deficit. Please, pick one. A softer dollar would be a key element in reducing the trade deficit. A strong
dollar would imply a wider deficit.
The Fed’s decision to embark on another round of asset purchases has been widely criticized, with
concerns raised by foreign finance officials, Sarah Palin, and even among senior Fed officials themselves.
There are two sorts of criticism. One is basically ignorance. Certainly, there are risks and uncertainties
associated with quantitative easing, but a lot of criticism is coming from people who know nothing about
monetary policy. Quantitative easing is simply expansionary monetary policy. The other criticism is the
one that happens whenever the Fed eases monetary policy (that is, the implications for future inflation) –
that is a valid debate. Many fear the rise in commodity prices (which are rising in all currencies, not just
the dollar). It takes a huge increase in commodity prices to have much of an impact by the time you get to
the consumer. The exception is the price of oil, which has a much more immediate impact on gasoline
prices (but as we’ve seen over the last decade, higher gasoline prices tend more to dampen economic
growth, not fuel the underlying inflation trend). Labor is the more significant cost for most businesses.
Wage pressures are low and productivity growth is strong, reducing labor costs per unit output. Do people
expect higher inflation from QE2? Well, that’s the point. Inflation expectations drifted lower into the
summer, until the Fed began discussing more quantitative easing. Those expectations are back to where
they were in the spring – they are not suggesting that the Fed has lost the handle on inflation.
Many supporters of deficit reduction also want to extend the Bush tax cuts. Pick one. There are good
economic arguments for temporarily extending the tax cuts, but a permanent reduction would have
serious implications for the deficit.
The increase in the deficit over the last couple of years is due largely to the recession and efforts to
minimize the impact of the economic downturn. Quantitative easing isn’t some hair-brained scheme, but
is simply another form of monetary policy accommodation. The dollar is down, but not out of line with its
longer-term trend. Stop the hysterics, please.
The Fed’s Asset Purchases
November 8 – November 12, 2010
As expected, the Federal Open Market Committee has embarked on another round of planned asset
purchases. In its November 3 policy statement, the FOMC wrote that it expects to buy another $600
billion in long-term Treasuries by the end of 2Q11 ($75 billion per month), in addition to the $35 billion
per month in reinvested principal payments from its portfolio of mortgage-backed securities. There has

5. been much criticism of the move in the financial press. Certainly, there are risks in the Fed’s strategy.
However, it’s hardly reckless or ill-advised.
The Federal Open Market Desk in New York plans to distribute its purchases across the following eight
maturity sectors based on the approximate weights below:
Nominal Coupon Securities by Maturity Range TIPS
1½ -2½
Years
2½-4 Years
4-5½
Years
5½-7
Years
7-10
Years
10-17
Years
17-30
Years
1½-30
Years
5% 20% 20% 23% 23% 2% 4% 3%
Why it the Fed expanding its balance sheet? The economy is in a liquidity trap. Short-term nominal
interest rates are near 0%. In a liquidity trap, fiscal policy is more effective at boosting growth than
monetary policy. However, with fiscal stimulus unavailable, or possibly negative, monetary policy is the
only game in town – and it can be effective, not through increasing the money supply, but by altering
expectations.
Quantitative easing is not something that the Fed just made up. It’s textbook economics (granted, at the
upper division or gradual level). People have been thinking seriously about liquidity traps and how to get
out of them for a long time. That doesn’t mean there aren’t controversies. Plenty of smart people have
their doubts. However, comments that quantitative easing is “reckless,” “financial heroin,” or other such
nonsense are not based on any theory of monetary policy.
So why is the Fed doing this? Basically, it’s real interest rates that matter. Inflation is too low, making
real interest rates too high. The Fed’s actions should lift inflation expectations (and apparently already
have). Lower real interest rates are stimulative. And as mentioned, fiscal stimulus is unavailable.
So what are the legitimate worries about quantitative easing? The Fed has relatively little experience with
this. The Fed’s first round of asset purchases (mostly mortgage-backed securities) was helpful in
stabilizing the financial system, largely because the Fed bought mortgage-backed securities when nobody
else would. This second round is different. Many fear that the Fed could be too successful in raising the
inflation rate and could possibly generate hyperinflation. However, the key here is the independence of
the Fed and its commitment to keep inflation low over the long run. The federal government has been

6. generating more debt and the Fed is taking down some of that debt, but those are separate decisions. In
a Washington Post op-ed, Fed Chairman Bernanke wrote that the Fed has the tools to unwind these
policies at the appropriate time and “will take all measures necessary to keep inflation low and
stable.” Ironically, the commitment to keep inflation low over the long term diminishes the effectiveness
of its asset purchases (because the goal is to increase inflation expectations). However, the Fed’s strong
commitment to low inflation signals that it won’t let things get out of hand.
One consequence of increased asset purchases (or any monetary policy easing) is higher commodity
prices and a somewhat softer dollar. However, a weaker dollar is not the goal (remember that the
exchange rate of the dollar is the Treasury’s responsibility, not the Fed’s).
Many worry about a possible bubble in the emerging economies (Latin America, East Asia, etc.).
Following the global financial crisis capital flows to these countries picked up. Certainly, this bears
watching in the months ahead.
Does the stronger-than-expected Establishment Survey data (from the October Employment Report)
change the outlook? Not much. Private-sector payrolls averaged a 136,000 gain over the last three months
– that’s enough to keep the unemployment rate steady over time, but not enough to push it significantly
lower. Job growth is still much too slow.
In his Washington Post op-ed, Bernanke wrote that “the Federal Reserve cannot solve all the economy's
problems on its own. That will take time and the combined efforts of many parties, including the central
bank, Congress, the administration, regulators, and the private sector. But the Federal Reserve has a
particular obligation to help promote increased employment and sustain price stability. Steps taken this
week should help us fulfill that obligation.”
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