IT IS not certain that the Fed’s QE2 is going to boost American consumption and investment. Consumers are not sensitive to interest rates when they plan daily consumption. In this time of severe recession, they may also not respond to low interest rates by buying more houses or cars. Firms are more sensitive than consumers to interest rate changes, but the slow growth of demand can delay their willingness to invest domestically. In the end, excessive liquidity will flow to other countries where real demand growth and asset values are more robust, putting pressure on those countries.

THE Fed may be on thin ice with its recent quantitative easing. The stated reasons for the programme have been that inflation is too low and bordering on the risk of deflation, and unemployment is too high. The fear of deflation is as overblown as it was from 2002-2005. If the Fed is following a credible nominal anchor then it shouldn't fear a temporary bout of falling prices because the public would understand that it is only temporary. Furthermore, having low inflation may be an opportunity for the Fed to start a price-level targeting regime. The high unemployment rate is the real reason why the Fed has followed its strategy just as it did in the previous two jobless recoveries. It is unclear the extent to which the elevated level of unemployment reflects a shortage of aggregate demand or problems on the supply side such as the extension of unemployment benefits, the problems in the housing market that make it difficult for people to move and other structural problems.

WITH QE2, the Fed is on the path of quadrupling the monetary base relative to its 2007 value. If the banks decide to lend out their excess reserves, M1 and M2 could quadruple relative to their 2007 levels, leading the price level to rise by a factor of four, i.e., we could see hyperinflation.

Now this would have some advantages.

AS I see it, the subprime crisis started as a run on shadow banks, which troyed much of the liquidity of financial instruments supported by shadow banking. This lowered their price and cut credit lines to activities supported by those instruments. In particular, the meltdown of mortgage-backed securities led to a significant decline in mortgage supply, resulting in a collapse of real estate prices, and massive wealth loss in the household sector. This depressed consumption and put a downward pressure on the stock market. Wealth loss also hit financial intermediaries, forcing them to recapitalize and lower their exposure to risky assets. This helped to spread the credit crunch across other sectors not directly exposed to shadow banking activities, further depressing the stock market. In the US, in particular, this gave rise to over-indebtedness and loss of credit access by households, small firms and State governments, a subset of the US economy that I am tempted to call "Emerging US" (E-US).

In contrast, however, "Advanced US" (A-US), composed of large corporations and the US Federal government, is awash with liquidity and can borrow at negligible interest rates. Can growth be spearheaded by A-US? A serious problem is that since E-US is unwilling or unable to spend and, as a result, A-US has no incentive to invest, unless exports are expected to increase at a high rate. Advanced economies are running into problems that are as serious as those in the US, so they are not a promising outlet of US exports. Emerging market economies (EMs), on the other hand, are a better bet but, as I will argue below, they have reasons to be leery about a sharp increase in imports driven by a surge of capital inflows.