September 13, 2012

 

• The president’s policies have failed, harming jobs and economic growth with the constant threat of tax increases, a record debt of more than $16 trillion, and an avalanche of job-harming regulations—there is no clearer indication than the Fed’s decision to expand on what was already the largest monetary stimulus in our history.

• At a time of negative real interest rates and trillions in excess reserves, there is little which monetary policy can achieve today to promote economic growth and much the Fed risks by today’s announcement.

• In addition to maintaining an “exceptionally low” federal funds rate (0 to 1/4 percent) into 2015, today the Fed announced an open-ended commitment to buy $40 billion per month in mortgage-backed securities (MBS).  There are limits to what monetary policy can accomplish, and it’s clear the Fed has reached them.

 

Since 2008, the Federal Reserve has implemented wildly accommodative monetary policies in response to the financial crisis and recession.  All told, the central bank has more than tripled the size of its balance sheet through the purchase of Treasury debt and securities from Fannie Mae and Freddie Mac.  These unconventional actions—with the stated intent of providing liquidity and support to the faltering economy—have been largely financed by increasing bank reserves, a component of the money supply.  With 43 consecutive months of unemployment above 8 percent in spite of the Fed’s so-called QE1, QE2, and Operation Twist programs, the central bank again announced more monetary easing in a misguided attempt at reviving the economy.

In the cases of both the 2000 dot-com market crash and the 2001 terrorist attacks, monetary easing was withdrawn relatively quickly.  However, concern continues to mount over how and when the Fed will reverse the massive balance sheet expansion of the past four years to contain long-term inflation and protect the value of the dollar. 

 

Fed Can’t Mandate Growth:  Quantitative Easing is intended to keep interest rates low in the hopes that businesses and consumers will borrow and spend.  The proximate justification for a policy of inducing more debt is that the sustained high rate of unemployment compels the Fed to try to stimulate economic activity under its “dual mandate” to support full-employment output and price stability.  But this model of credit-driven economic growth puts the cart before the horse, punishing savers and individuals on a fixed income who receive little to no return on their money when interest rates are repressed. 

Moreover, many credit an excessively low interest rate environment with leading to financial market weakness via global credit misallocations in the early years of the last decade, which precipitated the 2007-2008 financial crisis.  Perhaps more dangerous, Peter R. Fisher warned in a recent Financial Times op-ed, “[I]t is time to face the simple truth that, as they approach zero, lower interest rates will not automatically create more credit and more economic activity but, rather, run the significant risk of perversely discouraging the lending and investment that we need.”  This is known in economics as the dreaded “liquidity trap,” one of the reasons Japan’s economy has been stagnant for the past two decades.

 

Good Inflation?: Fed officials point to asset values (stocks, retirement accounts, real estate) as evidence of success for monetary easing through what’s known as the wealth effect (i.e. consumers will spend because they feel confident in the value of their house or their retirement savings vis-à-vis investments, etc.).  James Groth of the Reason Foundation explains the error in this approach:

There are few who would deny that the rates of return for stocks, real estate, and business equity depend primarily on the strength of the economy and how fast the economy is growing. Board members at the Federal Reserve, however, believe the converse: that the strength and pace of the economy is primarily dependent on the rates of stock, real estate, and business returns.

As such, their accommodative monetary policies target and inflate these very assets before the underlying economy justifies their returns. All Americans benefit from a healthy economy that provides higher wages, more purchasing power, and gains in productivity and innovation. Few benefit from higher asset prices when targeted and juiced by loose money.

In a zero-interest-rate world, capital chases the nominal returns of these financial assets instead of finding a more productive business use, which would otherwise result through higher returns on savings funding entrepreneurial investments.

 

Exporting and Importing Price Instability:  A side effect of expanding the global supply of dollars is a depreciating exchange rate relative to currencies of our trade partners.  To that point, Nobel economist Joseph Stiglitz warned in a Wall Street Journal op-ed prior to the last round of quantitative easing:

Lower interest rates may also lead to a weaker dollar, and the weaker dollar to more exports.  Competitive devaluation engineered through low interest rates has become the preferred form of beggar-thy-neighbor policies in the 21st century.  But this policy only works if other countries don't respond.  They will and have…[t]hey too can lower interest rates.  They can impose capital controls, taxes and bank regulations, and they can intervene directly in their exchange rate…

The upside of QE is limited.  The money simply won't go to where it's needed, and the wealth effects are too small.  The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted.  If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export.

The Fed’s policies erode the long-term value of the dollar and underweight the economic impact of rising commodity prices denominated in dollars.  On top of the steadily increasing prices of items such as food and gasoline, globalized supply chains lead to increased input costs of products manufactured around the world and ultimately result in higher prices for consumers, whether in the U.S. or abroad. 

 

Enabling Reckless Spending while Weakening the Dollar:  One marginal achievement of the Fed’s policies has been to lower the borrowing costs of the Treasury Department when it issues debt with the central bank as a willing buyer, which is another way of saying the Fed is bailing out the failed fiscal policies of the Obama administration—now on its fourth consecutive trillion dollar deficit in FY 2012.  However, as former Sen. Phil Gramm and Stanford University economist John Taylor noted in a recent op-ed, “The Fed's effort to use monetary policy to overcome bad fiscal and regulatory policy long ago reached the point of diminishing returns.” 

In the absence of pro-growth fiscal policies such as those in the House GOP Plan for America’s Job Creators—a fairer, flatter, simpler tax code, a balanced budget, and regulatory overhaul—QE3 will do more harm than good.  With no explicit plan for when or how this quantitative easing will be withdrawn, the Federal Reserve could do more for Americans struggling in the Obama economy by focusing singularly on maintaining the value of the dollar and protecting their purchasing power.