Despite assertions that it has ended its policy of quantitative easing (QE), the Fed is unlikely to be able to do so until it also ends its zero-interest-rate policy (ZIRP). This deadly policy duo has had terrible consequences for the American economy and every country using U.S. dollars.
It is as though the Fed were riding on the back of a double-headed monster. It cannot hang on forever, but it cannot dismount the beast without being devoured. As it is, the U.S. Treasury depends on ZIRP to fund America’s ballooning debt. When investors flee an enfeebled dollar the Fed is likely to be the “buyer of first resort” so that the price of Treasurys does not fall, pushing up interest rates. (So far Treasurys with low yields are still in high demand.) So with the Fed insisting that short-term interest rates will remain near zero “for an extended period,” a phrase used for the past two years, a new round of QE is almost inevitable.
For its part, QE involves flooding financial institutions with excess liquidity to try to flatten out the yield curve and depress long-term interest rates in hopes of sparking a recovery. But QE has created a massive overhang of excess reserves in the banking system that constitute repressed price inflation. And the sums involved are truly staggering: The Fed has injected at least $2.3 trillion into the financial system since Lehman Brothers collapsed in September 2008.
From late 2008 through March 2010 the Fed bought longer-term securities worth $1.7 trillion (QE1). This included purchases of $500 billion in mortgage securities and $100 billion in agency debentures with a target of $1.25 trillion for mortgage debt. Purchasing mortgage-backed securities and bailing out AIG and Bear Stearns, as well as buying other securities, led to a 140 percent increase in the monetary base.
In November 2010 the Fed began QE2 by buying an additional $600 billion in longer-term Treasury securities, a program that officially expired at the end of June. Yet the Fed has indicated it will continue buying Treasurys using proceeds from maturing debt it already owns.
With over $112 billion of the Fed’s government bond holdings maturing over the coming 12 months, replacement alone would involve purchasing over $9 billion of Treasurys each month. It also has more than $914 billion of mortgage-backed debt and $118 billion of debentures issued by government-sponsored enterprises (Fannie Mae and Freddie Mac). As such this is a “stealth” continuation of QE with only a limited, if any, decrease in the money-creation process.
For all the fanfare about QE, it must be said that it constitutes a last-gasp step and admission of the failure of other monetary policy tools. Consider the case of Japan. Its central bank, the Bank of Japan (BoJ), began asset purchases under QE to offset deflation and stimulate its ailing economy in early 2001. After nearly a decade of setting interest rates near zero the BoJ realized it had been unable to conjure up an economic recovery. Then after five years of gradually expanding its bond purchases, the BoJ exercised an exit strategy from QE in 2006, only to begin again.
Last March the BoJ increased its QE program from ¥5 trillion to ¥10 trillion (about $130 billion) scheduled until the end of 2012. Recently it announced another expansion to ¥15 trillion ($183 billion).
Incentives vs. Growth
A child untutored in economics might think it makes no sense to continue massive increases of liquidity into the economy that have been ineffective for so long. But most central bankers and many economists argue that previous amounts were too little and more is needed.
The incentives that QE and ZIRP create for commercial banks make it easy to see why these policies cannot promote economic growth. On the one hand, low interest rates reduce the cost of borrowing, which should encourage more investment spending. But on the other, commercial banks pay almost nothing to borrow yet receive interest payments from the Fed to hold excess reserves, making them unlikely to extend new loans.
A sufficiently high interest rate paid on bank reserves will induce banks to choose a risk-free interest-bearing asset rather than lending to private-sector borrowers. And so it is that commercial banks are earning record profits while making very few new loans.
The question of whether the Fed or the BoJ has an effective “exit strategy” from monetary expansion using near-zero interest rates and quantitative easing remains open. One possibility for the Fed is to engage in repurchase agreements (repos) to remove some of the excess liquidity that it pumped into the financial system.
These repos involve selling securities to commercial banks with the Fed agreeing to buy them back at a higher price at a later date. But once again commercial banks will find holding risk-free interest-bearing assets a much better bet than issuing new commercial loans.
In the end both QE and ZIRP have been ineffective in restoring economic vitality while also creating a massive overhang of repressed inflation. Most economists view business startups, especially small and medium-sized enterprises, as the key to economic recovery and growth. Yet QE and associated central-bank policies are diverting credit away from newly forming firms.
The Fed has now announced it will continue the “exceptionally” low short-term interest rates until the middle of 2013. This indicates that U.S. central bankers are unconvinced of the errors of their ways in their policy choices. That they are unwilling or unable to change course means the U.S. and Japanese economies are doomed to painfully slow economic growth for the foreseeable future.