FT: QE2 in U.S.

...Supporters of QE have received a huge boost in recent weeks. Since Ben Bernanke, Fed chairman, delivered a pivotal speech to central bankers in Jackson Hole, Wyoming, on August 27 – which made markets believe QE2 would come – the degree to which yields on spread between yields on regular 10-year Treasury bonds exceed those of inflation-protected 10-year Treasury bonds (a proxy for inflation expectations) has risen from 1.6 to 2.1 percentage points. In addition, the trade-weighted dollar has fallen more than 4 per cent.

These moves show that markets believe QE2 is capable of moving asset prices, at least. Lower rates and a weaker dollar should stimulate the economy. Mr Bernanke and the Fed believe QE works by changing the balance of risks on offer to the private sector. By buying large numbers of risk-free long-term Treasury bonds, they think they can force the public either to pay more for similar bonds or to invest in something else...

Plan B would most likely be a change in communication – whereby, instead of trying to push down long-term interest rates, the Fed would try to push up expectations of future inflation.

It could do this either by promising to keep interest rates close to zero for a long time – regardless of what happens to inflation – or by adopting a “price-level target”. A price-level target is, in essence, a pledge to compensate for low inflation today with higher-than-target inflation in the future.

“Clearly communicating an ex­pected path for prices would help guide the public’s understanding of the Fed’s intentions while we carry a large balance sheet and promise continued low interest rates for an extended period,” said Charles Evans, the president of the Chicago Fed, in a recent speech.

Plan C would be a more extreme form of quantitative easing. Instead of targeting an amount of assets to buy, the Fed could target an interest rate – such as 2 per cent for the 10-year Treasury bond – by offering to buy as many bonds as needed to reach that rate. Mr Bernanke raised this option in a famous 2002 speech widely seen as the instruction manual for how a central bank should tackle deflation.

Buying an unlimited amount of bonds means losing control of the Fed’s balance sheet, however, so it is a deeply unpalatable option. But it is not as extreme or unpalatable as plan D: buying as many Treasury bonds as Congress needs to cut all taxes on payrolls to zero for a time.

Such a policy would be extremely risky. It would be conceivable only if the US was already mired in deflation. But its existence gives the lie to any claim that the Fed would be out of ammunition if QE2 did not work.