Fed’s QEII Offers More Risk Than Reward
As the Federal Reserve Federal Open Market Committee (FOMC) meets today, it is widely expected that the Fed will announce a new round of quantitative easing (QE). The first round began in March 2009, as the Fed started large-scale purchases of Fannie and Freddie debt and MBS. The next round is expected to focus on purchases of long-dated US Treasuries.
The objective of QEII would be to reduce long-term interest rates, with the belief that such a reduction would spur investment and consumption, thus increasing employment. Estimated impacts on rates range from zero to 80 basis points (80/100s of one percent).
Given the large excess reserves in the banking system, it is likely that much of the monetary stimulus provided by QEII will simply be added to bank reserves, which would correspondingly have little to no impact on either lending or interest rates. So its likely that we will get very little bang out of QEII.
Even if QEII did lower rates as much as some Fed leaders claim, the impact would still be relatively small, under one percent. Given that mortgage rates have already fallen by that much over the last six months without changing the direction of the housing market, it is hard to see even a 1% decline in rates moving the economy. Quite simply, the major problem facing the economy today is not high interest rates.
The real impact, and the greatest risk, of QEII is that it changes expectations of inflation. It seems pretty clear that the Fed wants higher inflation than we have now. QEII sends the signal that the Fed will do everything possible to create that additional inflation. QEII also runs the real risk that the Fed ends up “monetizing the debt” – both reducing the political pressure to address our fiscal imbalances as well as undermining the dollar. I see these risks as easily outweighing what little bump one might get from a few basis points decline in long-term interest rates.
Bernanke on Monetary Policy
Every August, the Federal Reserve Bank of Kansas City sponsors a conference on monetary policy. It is the most valued invitation of the year for central bankers and Fed watchers. The Fed Chairman typically presents his views on monetary policy and the economy, and his talk inevitably makes headlines. (A select few reporters are invited.)
This year, Ben Bernanke promised the Fed will do whatever it takes to aid the faltering U.S. recovery, and most of all to prevent deflation. The problem for the Fed Chairman is that the central bank is plainly running out of options, as some had the cheek to observe. He suggested the Fed could do more of the same (purchase long-term securities), or try something new and untested (tweak the interest rate it pays on bank reserves).
Bernanke also suggested a third option, plus offered some professorial speculation on another. Taken together, these suggest the Fed may be prepared to chart a dangerous course.
In its policy statement, the Federal Open Market Committee has promised to keep interest rates low “for an extended period.” Bernanke suggested (as the third option) that the FOMC might make it clear that rates will remain low for an even longer period than markets are currently expecting. Within the Committee, there have been calls for caution and to remove the “extended period” language from the statement. These have been led by Thomas Hoenig, president of the KC Fed and host of the conference. By suggesting the only option was lengthening the period of low interest rates, Bernanke delivered the back of his hand to his host and the other inflation hawks on the FOMC.
Bernanke then mused about suggestions by some economists that perhaps the Fed should set an inflation target — that is, promise to deliver higher inflation rates to stimulate the economy. Fed chairmen do not engage in abstract speculation about policy, and to raise the inflationary option gave it place above all other possibilities. Bernanke hastened to add that there was at present no support for such a policy within the FOMC, and it “is inappropriate for the United States in current circumstances.”
In other words, the Fed chairman is thinking about an inflationary policy and, if circumstances change and he can build support within the FOMC, he is willing to implement it. When central bankers speculate in public about the possibility of an inflationary monetary policy, the currency is in jeopardy and the country in peril.
Inflation Warning
In the last few days, we have witnessed an almost unprecedented chorus of warnings about inflation prospects by senior Fed officials. Dallas Fed President Richard Fisher said the Fed must be prepared to tighten monetary policy by raising short-term interest rates with “alacrity.” President Charles Plosser of Philadelphia had spoken of the need to raise interest rates before unemployment returns to normal in order “to prevent the Second Great Inflation.” The comments of the two Reserve Bank presidents reinforce those made by Fed Governor Kevin Warsh.
Financial markets are confused because the Fed’s policy-making committee (the Federal Open Market Committee) had just indicated its intention to keep interest rates low for an extended period. The inflation warnings represent an internal debate that has gone public. Formal dissents from the FOMCs policy directive have reportedly been discouraged. So Fed officials are in effect offering up virtual dissents in public speeches. Confidence in Chairman Bernanke’s policy is waning.
Most economic forecasters profess to see little inflation risk. They need to reconsider their forecasts in light of the inflation warnings from within the central bank.
Tough Words
In the Wall Street Journal, Mary Anastasia O’Grady got Dallas Fed president Richard Fisher to go on the record about current Fed policy. He talks tough about inflation. “Throughout history, what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen.”
What is lacking is a plan to match the tough words with tough actions. Only when a tough and resolute U.S. president, Ronald Reagan, was matched with a tough and resolute Fed Chairman, Paul Volcker, did the Fed turn into an effective inflation fighter. There is no such match up now in the face of trillion dollar deficits forecast with no end in sight.
Ms. O’Grady describes Fisher as “the lead inflation worrywart” on the Federal Open Market Committee of the Fed. But Fed officials do not act in a political vacuum, and regional Fed presidents cannot on their own stop the Fed’s printing money in the face of the deficits. That requires leadership at the top from both the Fed chairman and the U.S president.
The Administration’s plan appears to be “to print their way out of an unfunded liability.” Thus far, despite tough words from some quarters, the Fed seems ready to accommodate “the political class.”
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