Why I Do Not Like QE2-Becker

 

 

Other governments, and their central banks, have reacted vocally and negatively to the Federal Reserve’s plan for another round of quantitative easing-which means that the Fed purchases long-term bonds. These negative reactions to QE2 outside the United States are presumably motivated by their self-interest, but I believe that another large-scale Fed purchase of bonds is also against American interests.

One justification frequently given for further Fed open market operations is that it will increase bank lending through raising bank reserves (“high powered” money). The reluctance of banks to lend has clearly been a factor in the slow down in the US recovery. Yet the Fed’s creation during the past couple of years of well over trillion dollars in additional reserves through open market operations has not induced rapid increases in bank lending. Instead, banks have accumulated huge amounts of excess reserves; that is, reserves above the amount they are required to keep as collateral for their deposit liabilities.

Given that banks already are holding such large reserves that carry low interest rates, it is hard to see why creating additional reserves will stimulate much additional lending. The big constraint in the lending market is that both borrowers and lenders perceive considerable risk to investments. This is partly due to government policies, like the health care and the financial reform bills, and proposals to raise taxes on higher incomes and on capital gains that will raise costs of doing business, and lower after-tax incomes of investors. Perhaps that perception will change due to the recent election of many Congressmen who say they want to lower taxes and reduce the size of government, but this perception of a risky investment environment will not change because the Fed creates large quantities of additional reserves.

The eventual inflationary impact of QE2 is another reason to be skeptical about its desirability. Before too long the US economy is likely to recover at a faster pace, and bank lending will then increase by a lot. At that time, the reserves created by the Fed will be converted through increased bank lending to businesses and households into money, such as currency and demand deposits. This growth in the money supply will create far more inflation than the Fed desires, unless the Fed dampens the growth by large scale selling of much of the several trillion dollars of assets it accumulated during the financial crisis.

The Fed does have the tools to control the resulting increase in inflation through selling these assets and reducing bank reserves. However, it is problematical whether it will have the political will to do that. Any large effort by the Fed to sell assets and reduce reserves will not only dampen the inflation rate, but the real economy as well. As a result, the Fed will be under strong political pressure to reduce their open market operations. Whether the Fed succumbs to that political pressure depends on Chairman Ben Bernanke’s willingness to fight the political battles.  Perhaps he will, but my guess is that a compromise will be reached whereby the Fed will tighten but less than it would like. The end result will be a greater rate of inflation than is good for the economy.

Central banks and other participants in currency markets are expecting an eventual significant increase in prices in the United States. This is why they have been trying to reduce their holdings of dollar-denominated assets that would decline in real value with inflation. These efforts in turn lower the value of the dollar relative to the euro, yen, and other currencies. Until the inflation rate actually increases by a lot, this reduction in the exchange value of the dollar reduces the prices of US goods in the international market. This in turn stimulates the demand for US exports, and reduces the demand by American consumers for goods made abroad. However, once inflation actually takes off, the process will tend to be reversed: demand for US exports would decline, and American demand for imports would go up.

In justifying the planned purchase of hundreds of billions of dollars of long-term bonds, Chairman Bernanke indicated that the goal is partly to lower long term interest rates relative to short term rates- which are already close to zero- and thereby stimulate longer term investments. A large purchase of long-term bonds would indeed lower long term rates relative to short -term rates, but the effect is not likely to be large. The reason is that long -term interest rates are essentially a weighted average of current and expected short-term rates, adjusted upwards for the greater riskiness and lower liquidity of long-term bonds. That is to say, the long-term shape of the interest rate yield curve is mainly determined by these fundamentals, and it is much less affected by changes in the relative supply of short and long-term assets.

Fed Chairman Bernanke wrote in an article in the Washington Post on November 4^th that "The Federal Reserve cannot solve all the economy's problems on its own." The slowdown in the recovery of the American economy is not the result of Fed policy, and cannot be cured by yet another bout of open market operations. This is why the Fed should curtail, and better yet, eliminate its plans for QE2.

 

 

 

 

 

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