The Fed Opens the Spigot
By Paul Ryan
Representing Wisconsin's 1st Congressional District
December 29, 2008 10:17 am

The Federal Reserve has been navigating unchartered waters for more than a year now, but the most recent Federal Open Market Committee (FOMC) statement signaled that our central bank is fast approaching the “final frontier” of monetary policy, with potentially dangerous economic consequences down the road.

In its latest bold move to combat the credit crunch and the worsening economic recession, the Fed lowered its target for the federal funds rate from an already-low 1 percent to essentially zero. In normal times, cutting its benchmark short-term interest rate is the Fed’s preferred, and most effective, tool for stimulating bank lending and lowering economy-wide borrowing costs for consumers and businesses. That, in turn, tends to encourage greater economic activity. But these are not normal times.

The level of fear and uncertainty in financial and credit markets is still such that banks are wary about extending new loans to borrowers with even solid credit ratings. Investors, meanwhile, have pulled back from a wide variety of securitized debt, which has restricted a key channel of financing for consumers and has increased borrowing rates on everything from car loans to credit cards, and even student loans. The bottom line is that the Fed can encourage lending by lowering interest rates, but it cannot force such activity.

Left with no more room to cut rates, the Fed has signaled that it is prepared to use other “nontraditional” means to resuscitate the economy. Our central bank still holds the ultimate trump card – the power to print money and flood the economy with cash. In some sense, it has already started to do just that. The Fed has been using its substantial balance sheet to extend loans to private businesses and establish various credit facilities for financial institutions and investors. Over the past three months alone, the asset side of the Fed’s balance sheet (which records such loans and liquidity facilities) has more than doubled from just over $900 billion to $2.3 trillion. The Fed’s most recent commitments to begin purchasing large amounts of mortgage-backed securities and provide financing for a wide variety of other asset-backed securities means that its balance sheet will likely exceed $3 trillion by early next year.

Where does that money come from? The Fed simply creates it by ramping up the money supply, which is recorded as an offsetting liability on its balance sheet. (Economists typically refer to this deliberate increase in the money supply by the central bank as “quantitative easing.”) 

It is important to note that this strategy is an explicit departure from the Fed’s policies of the past. Previously, the Fed had been “sterilizing,” or neutralizing, the lion’s share of its liquidity measures in order to prevent a sharp increase in the money supply. This was typically done by selling Treasury bonds in the open market. Essentially, the Fed was providing liquidity to certain segments of the financial markets with one hand, while taking cash out of the system through the sale of Treasury bonds with the other hand, which meant that the net supply of money in the overall economy remained relatively steady. (The Treasury facilitated this sterilization process through the creation of a temporary “Supplementary Financing Program” in September. The intent of this program was to sell extra bonds on behalf of the Fed in order to support the central bank’s increasing balance sheet.) Now that the Fed has essentially abandoned its efforts to sterilize its increasing balance sheet, the monetary spigots are wide open and the flow of liquidity will be unfettered.

In ordinary times, this sharp increase in the monetary base (defined as bank reserves plus cash in circulation) would be highly inflationary. But the sharp slowdown in economic activity, combined with the ongoing credit crunch, means that this enormous increase in high-powered money is not circulating through the economy via normal lending channels as it normally would, and is therefore not putting upward pressure on prices -- yet. 

Eventually, as the economy recovers, and banks begin lending again, the Fed will have to quickly mop up this excess liquidity and ramp up interest rates to prevent a potentially nasty bout of price inflation. And, frankly, I am not at all optimistic that the Fed can get the timing right. In fact, past Fed policy was a factor in creating the mess we are in now. Earlier this decade, the Fed held interest rates too low for too long, setting the stage for a wave of mortgage borrowing that eventually led to a housing bubble. Led by Chairman Bernanke, the Fed has proven to be extraordinarily bold and creative in addressing the worst economic and financial crisis since the Great Depression, but its task ahead in timing and executing the reversal of these actions will be herculean. 

Perhaps more important, the recent action on the part of the Fed could set the precedent for a dangerous interaction between monetary and fiscal policy going forward. For instance, the Fed also signaled last week that it is looking into the possibility of purchasing longer-term Treasury bonds as a way to bring down long-term interest rates and provide further support for near-term economic activity. But this measure is just a few steps removed in concept from one tempting, if entirely misguided, approach to funding our future fiscal liabilities. The Fed has the power to simply “monetize” the debt by printing money to meet these fiscal obligations. This is truly the nightmare scenario for anyone who cares deeply about sound money, a growing economy and fiscal prudence, as I do. I don’t believe we are heading down this path. But we do need to be careful not to mistake the unique policies the Fed is pursuing now in reaction to the current crisis as a viable template for securing long-term economic growth and fiscal sustainability.