Chief economist Richard Koo at Nomura Research Institute published a research report on March 25th titled “Post-QE forecast for leading economies: sunny, cloudy, or stormy?” In the report, Richard Koo suggests that the U.S. Fed is between the proverbial rock and a hard place in attempting to unwind the massive QE bond buying program.
Fed Chair Yellen’s recent testimony
Richard Koo: Fed less inflation-tolerant after QE
The key argument in Richard Koo’s thesis is that a central bank that has “juiced” the economy so much and for so long with QE cannot afford to be less than hyper-vigilant regarding inflation. “A central bank that has undertaken QE, on the other hand, has already supplied huge amounts of liquidity to the markets during the recession. These funds are harmless during a balance sheet recession, when there is no private loan demand and the money multiplier is negative at the margin. But once the private sector completes its balance sheet repairs and resumes borrowing, they have the potential to generate an immense amount of inflation.”
Richard Koo calls the current economic circumstances a “QE trap“. He says, “Countries that have engaged in quantitative easing will therefore see a sharper rise in long-term interest rates that can put the brakes on any economic recovery. I have dubbed this state of affairs the QE trap. From this perspective, the Fed’s first priority right now is preventing, or at least minimizing, a rise in long-term rates that is unwarranted by economic fundamentals. Once a central bank engages in QE, a certain (unwarranted) rise in rates during the recovery is probably unavoidable, but it must take actions to minimize that increase.”
Fed wants to stay ahead of the inflation curve
You can think of the Fed’s move like bluffing strength in a poker game. The Fed’s signaling that it will be vigilant and act decisively to head off inflation is an effort to solidify the impression that it will not fall behind the curve on inflation, thereby minimizing long-term interest rate increases caused by inflation concerns.