It seems like only yesterday that I was hearing from people that QE2 wouldn’t be very stimulative because what’s the point of lowering interest rates when rates are already low. Then last week I was hearing that the tax cut stimulus deal might be bad because it was pushing interest rates up a bit.
It seems to me that the right way to think about it is that these are two great tastes that taste great together. Fiscal stimulus helps the economy by boosting demand, but we need to worry that it will raise interest rates which puts a drag on the economy. But here comes Mr Bernanke who can buy bonds and keep interest rates low. Ta-da, economic boost! The combination of quantitative easing and payroll tax cuts is, in effect, a “helicopter drop” of money onto employed American. And the combination of quantitative easing and Unemployment Insurance extension is, in effect, a “helicopter drop” of money onto unemployed Americans.
The trick looking forward to the next recession would be to come up with some less agonizing, less ad hoc, more predictable monetary policy response to a situation in which the economy is depressed and nominal interest rates are near zero. You could give the Fed explicit legal authority to execute helicopter drops and establish some kind of “Taylor Rule” convention relating the scale of the drops to macroeconomic conditions. With that framework in place, the mere expectation that large drops will occur in depressed conditions should act as a stabilizing force and reduce the need to actually implement the recovery strategy. One of the challenges we faced as a country throughout 2008 is that nobody knew how the Fed would respond when rates approached the zero bound and everybody knew that nobody knew what would happen. This sort of thing tends to lead to panic and depression.