All Commentary
Thursday, April 21, 2011

Quantitative Uneasiness

In their recent paper, “Has the Fed Been a Failure?,” George A. Selgin, William D. Lastrapes, and Lawrence H. White conclude that over nearly 100 years the Federal Reserve’s performance has been mostly awful. Unfortunately, the Fed is currently engaged in a policy that will likely make a nice addition to their article.

This policy, known as Quantitative Easing (QE), consists of buying longer-term financial instruments, notably U.S. Treasury bonds and private mortgage-backed securities. Since the Fed engaged in one round of quantitative easing in 2008–10, the current round (announced last November, but signaled for months prior) has been labeled QE2.

QE2 is a departure from the Fed’s usual procedures, which aim primarily to affect short-term interest rates through purchases of short-term (less than a year in maturity) Treasury bonds, or T-bills. This tool of monetary policy, known as open-market operations (OMO), has largely been on the sidelines for the past two years, since the Fed drove the key short-term rate to near zero in late 2008 and has kept it there. The Fed turned to QE that year because the Great Recession was so severe. QE1 was primarily aimed at buying up MBS, many of which were considered “toxic” due to mortgages that were unlikely to be repaid. These MBS were like albatrosses around the necks of many banks, leading the Fed to try to help by taking these liabilities off their hands. Astonishingly, through $1.75 trillion of such purchases, the Fed increased the monetary base (currency plus bank reserves) by nearly 200 percent between December 2008 and March 2010.

However, rather than stimulating the economy through increased lending, much of that new money has remained idle, locked up in vaults as banks have been unwilling and often unable to lend. (Regulators in the past two years have considerably tightened lending standards, making it much more difficult to qualify for a loan, especially in these uncertain times.) Moreover, the Fed started to pay banks interest on their reserves held at the Fed. This is why the massive increase in the monetary base has not brought about much increase in the active money supply (currency plus deposits), which is necessary to stimulate the economy. This is also why the official inflation rate has continued to stay so low.

Given the failure of QE1 to return growth and unemployment rates to normal levels, the Fed has embarked on another round. In early November it announced it aims to purchase $600 billion in long-term Treasuries to bring down their yields (which act as the benchmark for many long-term interest rates) and spur lending, especially in the hard-hit real-estate markets, as well as increase inflation, which, according to the Fed, is too low to be consistent with a robust rate of growth.

The announcement of QE2 was received with widespread skepticism or even outright derision— from distinguished monetary economists such as John Taylor as well as politicians like Sarah Palin. Chairman Ben Bernanke and the Fed governors have, in return, mounted a major defense, with Bernanke even appearing on 60 Minutes in early December. But his protestations ring hollow. Every Fed chairman has sworn that he was not to blame for the economic calamities that occurred on his watch, and that without his actions things would have been much worse. It is always only years later that subsequent Fed policymakers are willing to acknowledge the Fed’s previous failures.

Inflation Expectations

The critics of QE2 have pointed to two problems with the policy: First, the Fed is seemingly ignoring the key role that inflationary expectations play in its ability to effect a macroeconomic result. The Fed’s actions are reminiscent of the 1960s, when the Keynesian economic mainstream relied on the now-discredited Phillips Curve theory to control the economy. The Phillips Curve purported to show a stable trade-off between inflation and unemployment; therefore the policymakers needed only to increase inflation to lower unemployment to an acceptable level. It turned out that this only worked as long as people’s inflationary expectations did not change—but of course as inflation went up, inflation expectations followed, ultimately leading to increasing rather than decreasing unemployment. After the painful stagflation of the 1970s, as well as the theory’s thorough drubbing by some of the most highly respected economists of the past half a century (including Milton Friedman), one would have expected the Fed to have permanently learned how difficult it is to control inflation expectations, as well as how fundamental they are to the Fed’s ability to control inflation itself. However, the Fed now appears committed to taking us down that road again. (And in fact Treasury yields went up rather than down in the first six weeks of QE2, possibly due to inflation expectations—a key component of long-term interest rates—themselves going up).

If the Fed Had a Hammer

The second problem with QE2 is that the Fed is stuck in an inappropriate economic model, which embodies the adage that when all you have is a hammer, every problem looks like a nail. The Fed really only has one policy tool: raising and lowering interest rates, whether short- or long-term. Therefore all economic problems seem solvable to the Fed through the use of this tool. The Fed has used it enthusiastically over the past ten years, bringing interest rates down to then-record levels in 2003–05, spurring a massive boom in both private and public debt and pushing the average savings rate negative for the first time in U.S. history. It is now increasingly accepted that loose monetary policy was one of the major causes—maybe even the primary one—of the Great Recession. For the past two years individuals and businesses have been slashing expenditures, increasing savings, and paying down debt—trying to get through the Keynesian hangover. But the Fed will have none of that: If Americans are not borrowing and spending enough, the Fed will lower not only the short-term rates but also long-term rates. In other words, it’ll make us an offer we can’t refuse—and we’ll be back on that not-so-merry-go-round yet again.

In response to these and other criticisms (leveled even by some of the Fed’s own, such as Kansas City Fed president Thomas Hoenig), Bernanke and other Fed officials responded in an unexpected way: They claimed the current policy isn’t actually “quantitative easing,” since the money used to purchase the Treasuries will not be newly created and therefore the monetary base will not increase. With QE1 the Fed “printed money” to purchase the assets, but this time it is simply “reinvesting” the funds that it receives from the maturing MBS in its portfolio.

This is a rather strange turn of events, as the Fed itself initially emphasized the $600 billion, making it appear that this will be a new injection and therefore a stimulus. But if the monetary base stays the same, it means only that the Fed is changing the composition of its balance sheet: fewer MBS, more Treasuries. That may have some macroeconomic effect (currently debated in the blogosphere), but certainly not very much, either on unemployment or inflation. Yet Bernanke and others have made a big deal about QE2 lowering long-term interest rates, stimulating the economy, lowering unemployment, and diminishing the danger of a deflationary spiral, something that they cannot possibly believe if QE2 isn’t really a quantitative easing.

So what exactly is going on here?

It is difficult to know. Economists are increasingly noticing the inconsistencies between the Fed’s words and deeds, but so far it has led mostly to head scratching. A likely explanation is that the Fed is trying to fool us—to convince us that there is an ongoing monetary stimulus, hoping that this will comfort investors and real-estate markets, while simultaneously reassuring inflation hawks that the policy will not further increase the monetary base, which has already gone up quite enough. If this conjecture turns out to be right, a notable victim of QE2 will be Bernanke’s commitment to his own ideals. He has been a leading proponent of inflation targeting, which stresses the importance of continuous and thorough communication with the public for the sake of transparency and accountability. All that appears to be out the window now. Not only is the Fed failing to be transparent, it may be guilty of actively misleading us. After three decades of increasing transparency, it seems that the Fed may be returning to its old ways.

It might be difficult to accept that the Fed would be willing to risk its hard-won credibility just to get some more short-term stimulus. Yet it is possible that this is all driven by a much bigger issue: U.S. fiscal policy, which has gone over the cliff in the past three years. The federal government has racked up $5 trillion in new debt in that time, with much more to come, financed through new Treasuries. Such a massive increase in supply has been driving down their price and pushing up yields—along with long-term interest rates. Given the extremely fragile real-estate market, rising long-term interest rates are the last thing the Fed wants, so it is not surprising that it would attempt to counteract them.

More problematically, the Fed may also be buying up Treasuries to keep down the financing costs of the federal government’s growing debt burden. If this is indeed what has been driving QE2—which the Fed, not surprisingly, vehemently denies—it would mark a sharp break with modern history. In the Accord of 1951, the Fed reasserted its control over monetary policy after ten years of pegging bond rates very low to make it cheaper for the federal government to fight World War II. If it begins to be perceived as the Treasury’s puppet again, investors could rapidly lose confidence in the prospect of both an economic recovery and low inflation, not to mention the long-term viability of the massive federal government debt.

Eventually the economy will start growing faster, likely leading to a rapid dislodging of currently idle reserves through cheap loans. As that cash starts entering the economy, inflation rates will inevitably be driven higher. The Fed may or may not keep this process under control, but it doesn’t even matter all that much, as the damage will already have been done. What Bernanke and most others at the Fed clearly fail to understand is Ludwig von Mises’s and F. A. Hayek’s fundamental point that artificial manipulation of interest rates by a central bank distorts microeconomic reality, perverting relative prices and sending the wrong signals to both entrepreneurs and consumers. This leads to faulty decision-making, resulting in more misallocations, malinvestments, and asset bubbles. In other words, by not allowing prices to fall to correct for the past artificial stimuli, the Fed is actually preventing the economy from adjusting and beginning a true recovery. QE2 continues this error.

  • Ivan Pongracic Jr. is an associate professor of economics at Hillsdale College, where he holds the William E. Hibbs/Ludwig von Mises Chair in Economics. He is a member of the FEE Faculty Network