QE-infinity: Two Views

What should we make of Ben Bernanke’s historic decision to link interest rates to an unemployment target? I take a negative view, but that’s just a reaction, not an analysis. Let’s turn the floor over to two experts, James Pethokoukis, who favors the move, and King Banaian, who doesn’t.

First, Pethokoukis:

Let’s look at the economy right now and identity what its biggest problems are. GDP growth will likely come in around 2% for the year, roughly the same as in 2011. And even without a fiscal cliff disaster, 2013 looks like another 2% year. Now, those numbers may make America the envy of other advanced economies, but they reflect an economy continuing to run far below its potential.

At the same time, the labor market remains in a depression. While the official unemployment rate has dropped a percentage point in each of the past two years, now standing at 7.7%, the collapse in labor force participation means that number greatly overstates the improvement — even when taking into account demographic factors. The “real” unemployment rate is more like 10%, and that’s not even including all the part-timers who wish full-time work. And the longer one is unemployed, the tougher it gets to find that next job.

And inflation, the other half of the Fed’s dual mandate? It’s running at under 2%, according to the Fed’s preferred measure. And the Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is a mere 1.53%.

Growth is the problem. And the Fed can be part of the solution.

How does Bernanke’s policy shift help solve the problem? Pethokoukis quotes economist David Beckworth:

It makes very clear to the public that the Fed will not stop until these targets are hit. Markets, in turn, should respond in anticipation of these goals being hit. That is, the elevated demand for liquid assets should start declining as households and firms start moving their funds into higher yielding assets. This rebalancing should raise asset prices, help repair balance sheets, and ultimately spur nominal spending. In other words, by better managing expectations, the Fed should cause the public to do the heavy lifting–and they already have started. If all goes according to plan, the Fed may not have to actually purchase that many additional assets. Ironically, this means that had the Fed been doing this all along its balance sheet would be much smaller now

But Banaian isn’t convinced:

This fall, the Fed had embarked on purchasing $40 billion in mortgage-backed securities (MBS) each month, to be paid for by selling off short-term Treasury securities (T-bills). This would induce private lenders to leave the MBS market and hopefully make loans to the business sector. Meanwhile, short-term interest rates would rise.

On Wednesday the Fed announced that they could no longer really do that, as they had sold all the T-bills they thought prudent. So now they will pay for those MBS with new reserves. And they will now purchase an additional $45 billion a month of long-term Treasuries (T-bonds), also paid for with new reserves. As the graph in Professor Taylor’s post makes clear, the expansion of the monetary base is exponential.

Reserves eventually become money. Currently, most reserves are held by banks who receive interest on them from the Fed. In short, the Fed is using its profits from operating in money markets to induce banks not to lend the reserves they are printing with one hand, while manipulating interest rates to encourage borrowing with its other. And this process threatens to debase our currency. The lone dissenting vote from Wednesday’s meeting, Richmond Fed president Jeremy Lacker, noted the Fed had only a few years ago agreed with Treasury that steering credit is not a job for monetary policy. Yet now that’s precisely what they’re doing.

But won’t the Fed make timely adjustments to prevent currency debasement? Banaian is doubtful.

The Fed expanded its reserves five-fold between the depths of the Great Depression and World War II — and never went back. The price level doubled between 1933 and 1948.

Today, the Fed has increased reserves from $800 billion to $2.6 trillion — a number that it says will rise $85 billion more each month until it gets an unemployment rate it feels better about, or until the inflation rate reaches a level well above its target. (The last two 4-week periods have had increases of $24 billion and $43 billion). This requires a foresightedness and deftness in monetary policy that the Fed has given me no reason for me to believe they possess. “Trust me, I’m from the Federal Reserve,” anyone?

Having heard from both sides, I guess I still take a negative view of the Fed’s historic gamble.


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