Is Further Quantitative Easing by the Fed Warranted? Becker

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.

 

Comments

[Michael Rutter]

I'm not sure that I follow. So granted that the Fed is close to exhausting it's arsenal, you still don't give much of a case against more QE. In fact you seem to go so far as to prove too much in favor of it. Short term inflation isn't a problem (moderate inflation might actually help deleveraging) as you said, which leaves the long term. We are presently in a severely distressing position with high unemployment with no end in sight - it is a little early to be talking about after the recovery. Monetary policy is all we have to fight this - surely this is a time for extraordinary action. As you said the Fed has the powers to fight inflation, and has done so effectively in the past. On balance even if the gain is small surely more action is warranted, and to discount QE on the grounds of a worry that the Fed will suddenly become impotent against prior experience seems a little odd. I hoe that didn't come across as hostile.

[chad]

I have been selling new homes for the past 10 years. Conventional loans have disappeared as loan limits have increased. Mortgage insurance has tripled as FHA loans have taken over. I have seen an increase in USDA loans as well. This seems to be one way to reduce reserves. As a nation we seem very egocentric when it comes to monetary policy. America has enjoyed its status as the dominant currency for a long time. The average citizen resists the notion that our economy is becoming more and more fragile with every one of these huge moves.

[TANSTAAFL]

So-called "quantitative easing" is a reckless experiment worthy of a banana republic, not the United States of America.

[Bernard King]

Even assuming the inflationary consequences are negligible, what is the point of printing more money if it simply remains locked up as "excess reserves" because no borrowers meet the unrealistic lending profiles?

[NEH]

Interesting... It seems we've rediscovered the problems of Privatised Banking Systems as opposed to a National Bank. The same arguments came to the fore when Congress authorized the Charters for the First and Second National Banks of the U.S.. That were later torpedoed by Jackson and resulted in the Financial/Commercial circus we have today.

Once again, remember, Banks exist for either Private Speculation or investment in Productive Enterprises (Hoarding at play?). Which has the greater Political Economic Benefit?

[Woj]

"Long term interest rates tend to be an average of current and expected short term rates"

This point gets overlooked far too often, especially by those worried about US rates spiking similar to peripheral Europe (http://bit.ly/MHi1Nx).

[Marc Freed]

I agree completely that the Fed can do little to promote growth beyond what they have already done, and that even some of that was pointless. What bothers me even more, however, is the apparent unwillingness of Bernanke to go to Congress and to explain that to them. When government spending accounts for more than 20% of a nation's GDP, and probably far more than that of global economic activity, fiscal policy has a role to play in moderating economic fluctuations. What fiscal policy, i.e. what combination of tax policies and public expenditures, is a legitimate topic of political debate; but abrogating one's legislative responsibilities on the alter of some inane economic ideology does not absolve any elected official of any political persuasion of responsibility for our continuing economic woes. Bernanke and his fellow Fed officials need to speak frankly to our feckless politicians and tell them they need to act quickly to prevent a more serious recession than the one we have already endured.

[Larry]

I don't know whether we should ease or tighten, but this piece seems to be oblivious to the important discussion of whether nominal income level targeting is a better approach than today's unreserved inflation targeting regime. That approach further recommends adjusting monetary policy so that the expected outcome matches the announced policy target, rather than announcing policy while announcing that the target will be missed. Israel has adopted this approach with stellar results.

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[bob love]

Does the central banks' increasingly permanent usurpation of the middle class' historical role of primary lender [via individual savings in banking intermediaries] to industry and government concern anyone? These "easing" actions are systematically destroying the vital role of the middle class in a healthy and balanced economy. This cannot be good ... unless we are intentionally moving towards economic feudalism [aka crony capitalism]. Perhaps, central banks have a role to play ... but it is not the role of the middle class.

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[David Peterson]

I agree with the basic proposition that the tools of conventional monetary policy have been exhausted. However, I do not agree that the Fed can do nothing further, though I believe anything they might hope to accomplish would require an Act of Congress to expand their powers. I don't think there is any denying that we are in a liquidity trap. We need new theories and new tools to understand how to get out.

The common explanation of the liquidity trap, i.e. that it corresponds to a flat region of the LM curve, or that it signifies that the public is indifferent between holding cash and holding treasuries, may be true, but they don't tell you anything about how to get out. You need to understand it on a different level in order to see the way out of the trap. Thus, let's engage in a little story-telling.

In 2008, the Fed saw the financial collapse, and said, "We aren't going to make the same mistake that the Fed made during the Depression. We're going to print money like mad."

So they did. They bought treasuries, and put newly-created money in the hands of the sellers of those treasuries. Let's say they started when the interest rate was 4%. They bought treasuries until the rate fell to say 3.9%. The people who held those securities thought, "I can sell out at 4%, and I have a better use for the money at 3.9%," so they sold.

But then the Fed realized it wasn't enough. So they did it again, this time buying from people who were holding at 3.9%, but who had a better use for the money at 3.8%.

But the Fed realized that even that wasn't enough, so the process continued until the rates were shockingly low, in the range of say .5%. At that rate, the Fed might want to do provide even more liquidity, but if it does, the people who sell their treasuries and take the money in exchange will simply let the money sit. Why? Because the only people who are left owning treasuries are people who have no use for the money anyway.

They may convert the treasuries in their vault to money, but the money will just sit in the vault like the treasuries did before. They have no intention of spending the money. The only reason they made the exchange is that the rate difference between the two assets is so small that it doesn't matter whether they hold it in cash or in treasuries.

So how do you get around this problem? Well, the problem is caused by the fact that the Fed has pumped too much money into just one market--the market for treasuries. Any time you pump too much supply into a market, you eventually exhaust the ability of that market to process more supply efficiently. The Fed has increased the stock of money, but it's not turning over, and the velocity of money is falling.

So the way around the problem is to look for other markets in which to conduct open market operations--markets that have not yet been inundated with money. You might think, "corporate bonds, asset backed securities..." The problem with these is that they are too closely related to the market for treasuries. A lot of the banks which sold their treasuries when the rates were coming down from 4% to .5% invested the money in these other assets. So those markets are also floating on a sea of money.

How about gold? Well, the Fed has bought some gold. But the problem with gold is that the market is so small that you quickly exhaust the ability of the market to process more money efficiently. At some early point, the price skyrockets, and you end up simply redistributing wealth from those who don't have gold to those who do have it, and will sell it to you for a very high price.

Any kind of consumer market is out as a possibility. For example, the Fed should not purchase automobiles. For one, the Fed has no use for autos. All it could do is store them, and that would result in depreciation. When it came time to tighten the money supply, there would be nothing of value to sell back to the public to drain off the money, and even if they did not depreciate, it would put the Fed in a position of competing with private manufacturers of those goods. So any kind of a consumer market is out.

What does that leave? Well it leaves only one thing I can think of: Real estate. Not consumer real estate, but commercial real estate: Office buildings, rented warehouses, apartments, hotels, retail space, etc. The Fed could purchase these properties at a deep discount, hold them until the economy recovers, collect the income in the interim, and then resell them to the private sector to drain off some of the excess money just before inflation sets in.

Why would this work better than buying treasuries? Because it's a very illiquid market. The people who own real estate are desperate to sell it, because they need the money. So the instant they get their hands on that money, they will turn it over, thereby increasing the velocity of money. They will pay their debts, they will pay the bank, the managers they owe money to, their accountants, their employees, their lawn guy, and if there is anything left over, they will probably spend that on themselves. But the net effect of this strategy will be to reduce leverage and increase liquidity in markets that are sorely in need of liquidity. As a result, this turns some of the wheels of the economic machinery, and soon, all of them will be turning. You don't get that result by putting more money into the market for treasuries. In fact, if you are worried about the stock of money, you could buy real estate, and sell an equal amount of treasuries, leaving the stock of money the same, but increasing the velocity of money in the process.

Notice that the purpose of this is to increase the money supply, not to inflate the price of real estate. In fact, one of the beauties of choosing real estate is that the market is so large that the Fed could purchase a lot of it without having any significant effect on the price.

You might notice a similarity between this policy and fiscal policy. Afterall, is the effect of Fed spending pretty much the same as the effect of spending by the other branches of government? But there are differences. One of the most important is that it's reversible. You can sell the real estate back to the private sector and drain off excess money, when the time comes. And from an accounting standpoint, this "spending" is not included in the budget, and so does not increase the deficit.

From a logistics standpoint, purchasing real estate is a bigger undertaking than purchasing treasuries. The Fed would need to conduct some due diligence relating to the value and cash flow of the property, and to title and environmental issues. However, a lot of this risk could be minimized by changes to the law. If the Fed is buying an office building from a bank REO department, it can get warranties from the bank (or they can be imposed by law). Afterall, the FDIC is on the hook for the losses if the bank goes under anyway, so the ability of the bank to make good on those warranties is not going to be an issue. Much of the cost and delay of buying real estate relates to the financing, and the Fed won't have that problem. It's going to simply write a check on itself to pay for it.

One might worry that we don't want the Fed owning real estate that competes with the private sector, or making decisions that are better made by private investors. But most of the decisional process can be avoided by having the properties managed by private management companies. One way to avoid the problem of competition would be to expand the program to vacant land that does not compete with anyone.

I recognize that this is a major change from what we have now, but it seems to me that the Fed has exhausted its conventional monetary tools. And fiscal policy cannot solve our problems. First, fiscal policy, whether it takes the form of an increase in spending or tax cuts, will increase the deficit, and that could be catastrophic under the current circumstances. Second, if fiscal policy takes the form of government spending, there is no real evidence that it would work. It's the private sector that needs to be stimulated, and spending only stimulates the public sector, with the possibility of a trickle down to the private sector. But the history of Obama's first term shows that spending is a very weak tool. That leaves only monetary policy, and because we are in a liquidity trap, that means we need to think outside the box.

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