The slow recovery of the US economy, and the much worse situation in Europe, is putting great pressure on the Fed to try to provide another monetary “stimulus”. I urge the Fed to resist this pressure mainly because further Fed easing under present circumstance will do little stimulating.
The Fed tries to stimulate economic activity through open market operations; that is, by buying assets, such as treasury bills, US government bonds, and debt issued by the private sector. These actions directly lower interest rates, and a little more indirectly also raise the reserves of banks. Through a variety of aggressive open market operations since the financial crisis began in 2008, the Fed has accumulated several trillion dollars of assets. In part due to these actions, interest rates on treasury bills are close to zero, and the excess reserves of American banks have increased to a mind-boggling level of almost $1.5 trillion.
The Fed cannot do much more to lower interest rates. Not only are short term rates close to zero, but long term rates are also quite low-interest rates on 5 year US government bonds are currently only a few percent. The Fed in what is called “Operation Twist” could try to further lower long term interest rates relative to the negligible rate on treasury bills by buying long term bonds. This might reduce further the spread in interest rates (that is, flatten the interest yield curve), but this effect is limited by a fundamental economic equilibrium condition. Long term interest rates tend to be an average of current and expected short term rates since more investors would shift into short term rates when long term rates are below this average; conversely, investors shift into long term rates when these are above the average of current and expected future short term rates.
Even with zero interest rates, advocates of a further “quantitative easing” (QE3) argue that the Fed’s purchase of government bonds and other assets would still increase reserves of banks, and that increased reserves will encourage further bank lending to businesses and households. The problem with this argument in the present situation is that, as indicated earlier, banks already hold huge levels of excess reserves. If banks are not lending more when they already have so many excess reserves, why would a further growth in these reserves increase lending by much, especially when interest rates are very low and the Fed pays interest on bank reserves- the current interest rate on reserves is 0.25%.
Even supporters of further Fed easing admit that QE2 had little effect on the economy (see, for example, the article in today’s New York Times by Christina Romer, former Chair of the Council of Economic Advisers). I submit that the reason for this is that QE2 mainly raised already large bank reserves to still larger levels without giving banks much incentive to increase their lending. For this reason, additional quantitative easing will likely also do little to help the economy.
Some advocates of further easing admit this, but claim there is virtually no downside, and that even a small gain is valuable in an economy that is doing poorly. I disagree with this argument because there is a downside to further easing, and this downside would more than negate the small gains to the economy.
I am not arguing that additional easing and the growth of bank reserves will pose a significant short-term inflation risk. The economy still has a lot of slack, and inflation is low. However, once banks start lending at the scale necessary to pull the American economy out of its doldrums, the money supply is likely to grow rapidly, which will increase the rate of inflation, perhaps to dangerously high levels.
Of course, in principle, the Fed has the tools to combat serious inflationary pressures. These include selling back to the private sector the assets accumulated by the Fed’s various easing actions. These sales would reduce bank reserves and reduce the ability of banks to add rapidly to the money supply. The other tool available to the Fed that became available during the past several years is to raise interest rates paid on bank reserves. That would encourage banks to hold on to more reserves rather than lend or buy other assets.
The major question is as much a political as economic one: will the Fed adopt these policies when that would risk slowing the recovery, and possibly create another recession? Congress and the President, no matter which political party controls these branches of government, would exert powerful political pressure on the Fed to use these weapons sparingly. Perhaps a strong Fed chairman would act, despite this pressure not to rock the boat. However, I do not believe this is a risk worth taking, particularly when further monetary easing would have at best small positive effects on the economy.