By Hamiltonicus
OK, you’re the Fed: what do you try next? Specifically, do you launch phase III of ‘quantitative easing’ (QE3) to stimulate more robust recovery with the risk of touching off damaging inflation? It need not be underscored that the whole world has a stake in U.S. Federal Reserve chairman Ben Bernacke’s deliberations. Some observers contend that the most powerful person in the world today is not President Obama, but chairman Ben. Upon termination of Quantitative Easing Phase II (QE2) in June and again in August last year, Bernacke indicated there would be no QE3 any time soon. ‘Soon’ may soon be behind us, however.
Hands of Big Ben
Like central banks elsewhere, the Federal Reserve (or ‘Fed’) manipulates interest rates by expanding or contracting supplies of circulating money. In normal times it does this by buying and selling short-term T-debt (government or ‘Treasury’ debt).
Fed purchase of T-debt puts cash into the hands of sellers (usually banks), thereby increasing the active money supply. With money more abundant, less interest can be charged to lend it: interest rates fall correspondingly.
Fed T-debt purchases push interest rates downward through a second mechanism, as well. They bid up T-debt re-sale prices, thereby reducing their ‘yield’ when paid off at maturity. (Regardless of its cost when purchased originally from the government (let’s say $85), a T-debt instrument that will pay $100 when redeemed at maturity carries an effective yield of 25% (20/80) if bought for $80 in the re-sale market but only 11% (10/90) if bought for $90.)
Falling yields on T-debt push general interest rates downward because investment money migrates away from T-debt and starts competing elsewhere for borrowers who will pay interest on new loans. As more potential loan capital chases the limited supply of sound lending opportunities, borrowers bid down what lenders can charge them in interest. The Fed’s hope, of course, is that, by making it cheaper to borrow, the resulting low interest rates will boost production and growth.
A head-scratching dimension of this is that the money the Fed uses to buy T-debt from the banks actually belongs to banks. Banks are required to park a mandated portion of their cash with the Fed as ‘reserves’ (hence ‘Federal Reserve Bank’) against failures or liquidity shortfalls and it is this cash the Fed uses to buy up T-debt. Hence, the government (the Fed) buys debt issued by the government itself (Treasury) from banks, using money actually owned by banks! And don’t forget that the cash Treasury borrows when it issues T-debt is largely owed to banks. Good luck explaining all this to Grandma.
When it seeks to push interest rates higher, the Fed sells T-debt held on its books and runs the whole machine in reverse, soaking in cash from buyers, thereby reducing supply of circulating money and forcing interest rates higher. Sales meanwhile push T-debt prices downward while their yields move inversely upward, pulling general interest rates higher as they go. Higher interest rates put a drag on production by raising borrowing costs and can thereby help keep a lid on prices for goods and services, even aside from the anti-inflationary effect of simply having less currency in circulation.
QE is something you try when you want economic stimulus, but interest rates are already so low that short-term T-debt purchases lose effectiveness. QE resembles short-term T-debt purchases, except that the Fed buys assets it normally avoids, such as long-term T-debt, corporate debt, and mortgage-backed securities (MBSs). All such purchases push cash out into the active economy, putting downward pressure on interest rates. Debt purchases meanwhile push bond prices up and give interest rates an additional downward nudge, as indicated above. Purchases also push MBS prices upward, with a roundabout benefit of producing lower mortgage rates, at least in theory (for another day).
The Fed has never before strayed so far into these instruments because short-term T-debt purchases proved adequate in stimulating growth and because short-term T-debt is highly liquid in ease of re-sale, precisely because owning it involves comparatively brief tie-ups of capital until maturity. One danger the Fed runs in purchasing less liquid assets is that this makes it harder to reverse course through quick selling when inflation rears its ugly head and interest rates need to be raised, not lowered.
Another contrast with traditional monetary stimulus is that QE does not rely on reserves for the necessary purchases. Instead, the Fed simply credits new money to its account by fiat and transfers them to the banks from which it acquires securities. This gives fresh meaning to the metaphor of ‘printing money’ and carries clear inflationary implications.
Getting the Bens
Some observers praise QE1– $1 trillion between late 2008 and June 2010, mainly in MBS purchases—for ameliorating the U.S. financial emergency by loosening credit. Applause is more muted for QE2: $600 billion between November 2010 and June 2011, mainly in long-term T-debt. Ambitiously aimed at stoking more rapid growth, QE2 instead left an aftermath of continued sluggishness, with unemployment stuck at levels that would be high for a normal recession, let alone the current ‘recovery.’
Three items round out the current situation. First, the Fed has since late last year been implementing ‘Operation Twist,’ which will amount to $667 billion by its scheduled termination at the end of the year. ‘Twist’ seeks to stimulate new borrowing by pushing down long-term interest rates without increasing the overall size of Fed securities holdings. It does so by purchasing long-term T-debt while selling short-term T-debt in equal volumes. Of course, this will tend to push short-term borrowing costs higher—the opposite of traditional monetary stimulus—while attempting to bring long-term borrowing costs down. Moreover, with long-term interest rates already well below 2%, how much effect is really likely, especially considering all the other factors that can influence rates long-term? After a number of months, ‘Twist’ seems to be a fizzle, justified only by a ‘try anything’ frame of mind.
Second, the Fed announced in late February that it did not expect interest rates to rise before 2015. Chairman Ben added that the Fed will target an inflation rate of 2% and that it could easily prevent higher interest rates through resumed bond-buying, without inflationary worries. His interest rate forecast amounted to the Fed’s prediction of what its own situation and actions would be over the next three years: it will not feel compelled to stifle accelerating inflation with hiked interest rates because price increases will remain at acceptable levels. The Fed recently completed a study of its own record in predicting economic trends and found that it does worse than private sector analysts, who are pretty bad themselves. Stocks nevertheless rallied for a while on Bernacke’s forecast of continued low interest rates. Over the late spring and summer, the effects of his forecast have been shrouded by those stemming from general U.S. economic news and the ongoing ‘Euro-crisis.’
Third, Bernacke hinted back in the spring that, with recovery still weak, QE3 may be around the next bend, at first probably focused on more MBS acquisitions to reduce mortgage rates and thereby stimulate home purchases and construction industry recovery.
Concern is mounting that Bernacke’s extraordinary past, present and possibly future moves will touch off ruinous inflation and wreak other damage without having accomplished much that’s positive. Monetary stimulus has been analogized to ‘pushing on a string’ even in normal times and these are not normal times.
More Ben-efit?
One critique is that chairman Ben is denigrating the recovery in order to boost it. His low-rate forecast implies scepticism about growth when what the recovery really needs is a signal of confidence. Better he should predict higher interest rates, suggesting that he expects growing demand for money in an accelerating economy. One theory is that by predicting stable low interest rates Bernacke hopes to keep boosting stock markets, thereby fueling both new investment and the ‘wealth effect’ spending brought by higher equity prices. But if the key factor now is confidence not interest rates, which are already near rock bottom, Bernacke’s manoeuvers through further rate reductions and stock rallies seem roundabout.
Predicting prolonged low rates may retard recovery in other ways as well. First, expectation of prolonged low rates might induce potential borrowers to delay rather than take loans out now. But if borrowers thought rates would be going up, the opposite would be true: buy that house or launch that new business today while loans are cheap. Second, prolonged low interest rates might deter savings, thereby augmenting the very credit shortage they seek to forestall. After all price caps never alleviate a shortage; they worsen it by eroding supplier incentives.
Many critics feel Bernacke is underplaying the risk of serious inflation and some see echoes of the situation and policies that produced ‘stagflation’—prolonged stagnation combined with substantial inflation—back during the seventies and eighties. Chairman Ben projects low inflation based on ‘core’ numbers that exclude food and energy prices because they both tend to fluctuate a lot. But if food and energy are included, inflation registered closer to 3% than 2% in the spring, though lower recently as energy prices have fallen.
Of course, some feel that a little inflation right now might not be a bad idea. For one thing, it allows debtors—including the U.S. government—to pay debts down with more abundant, cheaper dollars. Second, it conceivably prompts households and firms to spend now rather than later when things will cost more. For households this seems dubious, however, at least for the moment. U.S. household spending is sharply down since 2008 as American families struggle to save and get out of debt. They are not there yet.
Moreover, say Ben’s critics, we’re tumbling not toward a little inflation but a lot. On the fiscal side, potential inflationary pressure is heavily wired into enormous and rapidly growing government deficits: Uncle Sam persistently pushing out way more money in expenditures than it collects back in taxes. Unless the 2012 elections swing heavily toward one party or the other, there is no reason to think that the current budget gridlock—Republicans refusing to raise taxes and Democrats refusing to cut spending—will resolve itself any time soon.
Accelerating U.S. inflation would bring downward drift in the dollar’s value and flights to inflation-hedging commodities, notably oil, which would see upward pressure. Higher oil prices mean pain for Sri Lanka, of course, as we saw earlier this year and so would a weaker dollar, slicing into exports. Brazil, which also lives by exports, has been criticizing Bernacke loudly for his dollar-weakening ways. It seems plausible that Sri Lanka’s springtime recent rupee depreciations, close on the heels of chairman Ben’s delphic February pronouncements, sought to keep exports out ahead of anticipated decline in the dollar. (As it turned out, the dollar more than held its value in intervening months as the ‘Eurocrisis’ drove fright money to the U.S.)
In response to reproaches, Bernacke would probably remind us that worldwide recovery depends heavily on restoring prosperity and high spending to the American consumer, which is exactly what he’s trying to do. Moreover, Bernacke continues to ask his critics: if inflation is such a huge danger, why aren’t we seeing any? Nevertheless, should he run the risk of inflation from QE3, when QE2 seems to have done so little good? I’m not here to bash the beleaguered chairman. Lord knows he’s got way too much on his plate for anyone to handle. But I do have a thought on what he should try doing next: nothing.