What, Exactly, Is The Federal Reserve Up To?
The Federal Reserve is injecting $ 600,000,000,000 into the economy, primarily in the hope that it will boost stock prices and, in turn, the economy. It might work, but if it doesn't the consequences could be severe.
Yesterday afternoon, the Federal Reserve announced its latest effort to try to inject some life into what has been a fairly stagnant economy:
The Federal Reserve escalated its efforts to get the U.S. economic recovery back on track Wednesday, again entering the realm of risky and untested policy in response to the worst downturn in generations.
The plan to pump $600 billion into the financial system is designed to stimulate the economy in large part by lowering mortgage and other interest rates.
Although the approach carries significant risks for both the economy and the central bank’s credibility, the steps announced by Fed policymakers could represent the nation’s best hope for breaking free of sluggish growth, especially with bold initiatives unlikely from a newly divided Congress.
Fed officials concluded that growth is too slow to bring down the 9.6 percent unemployment rate and is at risk of staying that way for some time absent new action. They were also concerned that inflation has been running too low and were looking for a way to encourage modest price increases, which would give consumers and businesses more reason to spend money before its value declined and help energize the economy.
“The pace of recovery in output and employment continues to be slow,” the Fed’s policymaking panel, the Federal Open Market Committee, said in a statement. “Employers remain reluctant to add to payrolls. Housing starts continue to be depressed.”
The Fed usually manages the economy by adjusting short-term interest rates. With those rates already near zero, Fed officials had to dust off a strategy for boosting the economy that debuted during the darkest days of the financial crisis. The Fed plans to create money, essentially out of thin air, and then pump it into the economy by buying Treasury bonds on the open market. These purchases are to be finished by the end of June, the Fed said.
Using this technique, called “quantitative easing,” the Fed bought more than $1.7 trillion in securities during the financial crisis and in its immediate aftermath. The central bank’s holdings jumped to their current level of $2.3 trillion, and the figure will approach $3 trillion when the new purchases are complete. This new wave of bond buying is a dramatic turnabout for an institution that just six months ago, amid a false spring in the economy, was weighing how it would begin unloading all the securities it had purchased.
The Fed action, which is aimed in part at making it cheaper for Americans to take out mortgages and for businesses to borrow money to expand, influenced the market even before the steps were formally unveiled. Average mortgage rates had already fallen from 4.5 percent for a 30-year fixed-rate loan over the summer, when Fed officials first said they were considering new steps, to 4.2 percent last week.
Fed Chairman Ben Bernanke took to the Op-Ed pages of The Washington Post this morning to justify this decision:
Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Bernanke concludes, though, with this comment:
The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector.
As Daniel Drezner points out, though, this last part has some very interesting political consequences:
If Congress and the administration can’t agree on anything, then the only public actors capable of taking concrete action on the economy are the central bank and the regulators. These institutions are already ridiculously unpopular. Being forced to take imperfect actions because of elected branch paralysis won’t help matters (compared to fiscal and tax polcies, there’s only so much that quantitative easing can do to stimulate the economy). If you think hostility to elected elites is high, wait until the focus switches to unelected elites.
Indeed, opposition to Federal Reserve secrecy, for example, is an issue that has united both right and left during the current Congress, and with Ron Paul likely to be handed the Chairmanship of the House’s Monetary Policy Subcommittee, one imagines it will be a bigger issue after January 3rd.
Beyond the politics, though, there’s the question of whether what the Federal Reserve is doing here is the right thing. Brad DeLong, for example, points out that the actual impact of the new policy amounts to about $7 billion in a $ 60 trillion economy. At the same time, though, the Fed’s action poses the risk of unleashing an inflationary spiral that would do more damage than the stagnation we’re experiencing now:
For all intents and purposes that $600 billion is being borrowed. As the government’s banker, the Fed can borrow money, and pay it back when it chooses to, by selling off the bonds that it will be purchasing. The effect of this kind of action is the same as if Congress was appropriating another “porkulus” it dumps cash into the economy by increasing our federal debt. This move is essentially ignoring the message the voters sent to the government yesterday, even worse, it is economic suicide.
Here’s the problem, by “printing” all of this extra cash our government is trying to create inflation and “spur the economy” with this move there is a real chance of creating hyperinflation. That’s exactly what Germany did in the late 1920’s.
The famous Economist, John Maynard Keynes described this situation in The Economic Consequences of the Peace: “The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance.
And now our Keynesian President, is allowing the Fed to go against Keynes’ advice.
Federal Reserve critics have been warning about the dangers of inflation for some time now, and the fact that it hasn’t manifested itself so far has been taken by some as a sign that it isn’t a problem that we need to worry about right now. That’s the thing about inflation, though; by the time it becomes a problem worth noticing it’s often too late to do anything about it. In fact, there may already be signs that inflation1 is having an impact on prices:
In normal times, a Fed spending spree on government bonds would be highly inflationary, because it would flood the economy with money and raise worries about too much government spending. The mere worry of too much inflation in financial markets could drive long-term interest rates higher and cause the Fed’s program to backfire.
Michael Pence, a top Republican in the House of Representatives, said the Fed was taking an “incalculable risk.”
Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, who described the move before the meeting as a “bargain with the devil,” was the lone dissenter in a 10-1 vote of the Fed’s policy committee. He said the risks of additional government bond purchases outweighed the benefits.
The Fed is taking the gamble that the economic is so stagnant at the moment that it can absorb the increase in the monetary base without creating price inflation. If they’re wrong, however, we could be paying the price for this decision for years to come.
More broadly, though, Bernanke’s Op-Ed reveals a strategy that, at heart, is aimed at creating another asset bubble even if that’s not being explicitly acknowledged. The Fed is essentially creating $ 600,000,000,000 of “new money” in the hopes that it will push stock prices up, which it in turn hopes will stimulate consumer spending, which in turn it hopes increases business investment and hiring. It’s a very Rube Goldberg-ian vision of how to stimulate the economy, and it seems to me to be exactly the wrong thing to do at this point. It isn’t the job of the Federal Reserve to push up stock prices, or at least it shouldn’t be, and an economic recovery that is based primarily upon increased financial speculation strikes me as very fragile indeed, and basically amounts to repeating the same mistakes that got us into the mess we’re trying to get out of.
This is a good opportunity to point out that inflation is not increased prices. Inflation in the context of economics was traditionally defined as an increased in the money supply. Price increases are the consequence of that inflation. In popular usage, however, inflation has come to mean an increase in the general price level. This confuses the issues of what causes that increase, however.