With the benefit of hindsight, Quantitative Easing, as practiced by the Fed in late 2008 and from Oct. '10 through Mar. '11, was justified since at the time it helped satisfy the world's intense demand for highly liquid, dollar-based safety. A failure to satisfy a surge in the demand for dollars would have been deflationary, since it would have resulted in a shortage of dollars. The need for more dollar-based liquidity can be seen in certain market-based indicators prior to each round of quantitative easing.
The above chart is arguably the best measure of the value of the dollar relative to our trading partners, since it adjusts the dollar's nominal value for changes in relative inflation. As it shows, the dollar rose prior to the onset of each round of Quantitative Easing, signaling that the world's demand for dollars was exceeding the Fed's willingness to supply dollars. Following each round of QE, the dollar's value fell, which in turn suggests that the Fed ended up over-supplying dollars to the world. Unfortunately, the dollar is now at its lowest level ever. There is no sign now of any shortage of dollars or unsatisfied demand for dollar liquidity. Just the opposite: the world is awash in dollars. More dollars would only depress its value further, resulting in rising inflation.
This chart shows the market's forward-looking inflation expectations, and is derived from the yields on 5-yr TIPS and 5-yr Treasuries. First, recall that 1997 was the year that S.E. Asian currencies plunged against the dollar. Huge devaluations created an intense demand for dollars at the time, but the Fed ignored this and remained in a tightening mode through early 2001. Inflation expectations plunged as a growing scarcity of dollars led to a very strong dollar in early 2002 and eventually to the U.S. economy's flirtation with deflation in 2002-2003. Second, note that QE1 and QE2 both came at a time when inflation expectations were falling, a sign that the Fed needed to respond to an emerging scarcity of dollars. Today, however, inflation expectations are rising, and that argues strongly against another round of quantitative easing.
This next chart just makes the point again. Not only were sensitive market-based indicators signaling the need for quantitative easing, core inflation measure were also. The core CPI suffered some significant declines in the months preceding the onset of each round of quantitative easing. Currently, however, most measures of inflation are rising, and that argues strongly against another round of quantitative easing.
There is a common thread to most of the world's economic and financial problems these days, and that is excessive government intervention in markets and excessive government spending financed by debt. Decades of policies designed to make housing more affordable gave us the housing bubble, and policies and government subsidies geared to make it easier for people to get mortgages gave us the subprime mortgage crisis. Together, they almost brought down the global banking system. Generous government pensions and early retirement have bankrupted Greece, and our own social security and medicare systems are critically under-funded thanks to politicians' inability to resist the urge to increase benefits without regard for costs or the discipline of free-market price mechanisms.
It's time for policymakers to take a deep breath, step back, and let markets sort things out for a change. No matter how smart they may be, technocrats can't match the collective wisdom of free markets. Please, no more quantitative easing, no more extensions of unemployment benefits, no more taxes, no more regulations, no more mandates, no more stimulus. Victor Davis Hanson explains this more eloquently than I can:
We are witnessing a widespread crisis of faith in our progressive guardians of the last 30 years. ... We are living in one of the most unstable — and exciting — periods in recent memory, as much of the received wisdom of the last 30 years is being turned upside down. In large part the present reset age arises because our political and cultural leaders exercised influence that by any rational standard they had never earned.
If the Fed screws up enough courage to take a pass on QE3 today, I for one will breath a huge sigh of relief.
UPDATE: Following its meeting, the FOMC's statement noted that the economy had weakened considerably, but refrained from announcing another quantitative easing program. Instead, the statement said that it likely would keep short-term interest rates "at exceptionally low levels ... at least through mid-2013." Markets are reacting with apparent disappointment (yields down and equity prices down, both reflecting weaker growth expectations), but it's not unusual for the market's initial reaction to a monetary disappointment to be wrong. The market was hoping for additional easing, and so is disappointed by the lack of a QE3. In my view, no additional easing is good news for the dollar, and that in turn is likely to prove good for the economy.