The Federal Reserve, the ‘Twist,’ Inflation, QE3, and Pushing on a String
In a move that some are calling QE3, the Federal Reserve announced yesterday that it will engage in a policy called “the twist” — selling short-term bonds and buying long-term bonds in hopes of artificially reducing long-term interest rates. If successful, this policy (we are told) will incentivize more borrowing and stimulate growth.
I’ve freely admitted before that it is difficult to identify the right monetary policy, but it certainly seems like this policy is — at best — an ineffective gesture. This is why the Fed’s various efforts to goose the economy with easy money have been described as “pushing on a string.”
Here are two related questions that need to be answered.
1. Is the economy’s performance being undermined by high long-term rates?
Considering that interest rates are at very low levels already, it seems rather odd to claim that the economy will suddenly rebound if they get pushed down a bit further. Japan has had very low interest rates (both short-run and long-run) for a couple of decades, yet the economy has remained stagnant.
Perhaps the problem is bad policy in other areas. After all, who wants to borrow money, expand business, create jobs, and boost output if Washington is pursuing a toxic combination of excessive spending and regulation, augmented by the threat of higher taxes.
2. Is the economy hampered by lack of credit?
Low interest rates, some argue, may not help the economy if banks don’t have any money to lend. Yet I’ve already pointed out that banks have more than $1 trillion of excess reserves deposited at the Fed.
Perhaps the problem is that banks don’t want to lend money because they don’t see profitable opportunities. After all, it’s better to sit on money than to lend it to people who won’t pay it back because of an economy weakened by too much government.
The Wall Street Journal makes all the relevant points in its editorial.
Read the rest of this post »
Easy Money from the Federal Reserve Is Not the Solution for America’s Economic Problems
Allen Meltzer, an economist at Carnegie Mellon University, writes today in the Wall Street Journal about the Fed’s worrisome announcement that it will continue the easy-money policy of artificially low interest rates.
Professor Meltzer’s key point (at least to me) is that the economy is weak because of too much government intervention and too much federal spending, and you don’t solve those problems with a loose-money policy – especially since banks already are sitting on $1.6 trillion of excess reserves. (Why lend money when the economy is weak and you may not get repaid?)
Meltzer then outlines some of the reforms that would boost growth, all of which are desirable, albeit a bit tame for my tastes:
[T]he United States does not have the kind of problems that printing more money will cure. Banks currently hold more than $1.6 trillion of idle reserves at the Fed. Banks can use those idle reserves to create enormous amounts of money. Interest rates on federal funds remain near zero. Longer-term interest rates on Treasurys are at record lows. What reason can there be for adding more excess reserves? The main effect would be a further devaluation of the dollar against competing currencies and gold, followed by a rise in the price of oil and other imports. …Money growth (M2) reached 10% for the past six months, presaging more inflation ahead.
…What we need most is confidence in our future. That calls for:
- Reducing corporate tax rates permanently to encourage investment (paid for by closing loopholes).
- Agreeing on long-term reductions in entitlement spending.
- A five-year moratorium on new regulations affecting energy, environment, health and finance.
- An explicit inflation target between zero and 2% to force the Fed to pay more attention to the medium term and to increase public confidence that we will not experience runaway inflation.
The president is wrong to pose the issue as more taxes for millionaires to pay for more redistribution now. That path leads to future crises because higher taxes support the low productivity growth of the welfare state, delay the transition to export-led growth, and do not reduce future budget liabilities enough.
Meltzer’s final point about the futility of class-warfare taxes is very important. He doesn’t use the term, but he’s making a Laffer Curve argument. Simply stated, if punitive tax rates cause investors, entrepreneurs, and small business owners to earn/declare less taxable income, then the government won’t collect as much money as predicted by the Joint Committee on Taxation’s simplistic models.
Of course, Obama said in 2008 than he wanted high tax rates for reasons of “fairness,” even if such policies didn’t lead to more tax revenue. That destructive mentality probably helps explain why not only banks, but also other companies, are sitting on cash and afraid to make significant investments.
But if you really want to understand how Obama’s policies are causing “regime uncertainty,” this cartoon is spot on.
Diamond Down
Today Nobel Prize-winning economist Peter Diamond announced he is withdrawing his nomination to the board of governors of the Federal Reserve System.
Professor Diamond, in the pages of New York Times, blames the opposition to his nomination on both partisan politics and what he sees as a misunderstanding of the relationship between unemployment and monetary policy. Mr. Diamond, however, is the one with a fundamental misunderstanding. We all know unemployment is an important issue and needs to be addressed. The question is whether it can be addressed with loose monetary policy. Mr. Diamond apparently believes it can. There are many who believe it cannot. If all our labor market problems could be solved with loose money, then we’d already be at full employment. In case Mr. Diamond didn’t notice, we aren’t. We also have gone down this path too many times before. The belief in a long-run trade-off between unemployment and inflation has the been source of considerable economic harm.
It is interesting that Mr. Diamond does not address the legal obstacles to his nomination. The foremost is that there can only be one board member from the same Fed district at any one time. As Mr. Diamond notes he has been at MIT “since 1966″ and not living in Chicago, as the White House claims. Whatever his academic qualifications, by law he is prohibited from serving on the Fed Board. If congressional Democrats don’t like the law, they can try to change it, but we should not just ignore it. Such only breeds a contempt for the law and a belief that the laws only apply to the masses and not the elite.
So to answer Mr. Diamond’s compaint that ” Nobel isn’t enough,” I would answer: Exactly. A Nobel does not place one above the law. Sorry, Professor, you’re going to have to live with the same rules that apply to the rest of us.
Ben Bernanke: Central Planner
There’s a great piece in the spring issue of The Independent Review on Federal Reserve Chairman Ben Bernanke by San Jose State Professor Jeffrey Rogers Hummel. Although a bit long, its well worth the read for anyone wanting to understand both Bernanke’s thinking and his actions during and since the financial crisis.
First, Prof. Hummel discusses the differences between Bernanke’s and Milton Friedman’s explanations for the Great Depression. Those that debate whether Bernanke’s actions, especially the quantitative easings, would be approved of by Friedman will get a lot out of this discussion. From this comparison, you get the point that Friedman was concerned about overall credit conditions and liquidity, whereas Bernanke is less focused on the monetary factors than on the impairment of credit intermediation, which explains his support of selective bailouts.
Hummel’s comparison of Greenspan and Bernanke is also insightful, particularly since many (myself included) often lump the two’s policies together. From the analysis, it is clear that Greenspan falls into the Friedman camp, his “rescues” were of the financial system in general, and not of specific firms.
One might say a bailout is a bailout, so what’s the difference between rescuing the system and rescuing individual firms within the system? Certainly that’s a view I have some sympathy for. The “Greenspan put” was as much a contributor to reckless risk-taking as anything else. Hummel, however, discuses why this difference ultimately matters, and why it shows Bernanke to fit the role of economic central planner. In short, the facts are presented that during the financial crisis, Bernanke did not actually increase overall liquidity by much, he re-directed it to those firms he deemed most important. This process of reducing liquidity to some sectors while re-directing it to others, arguably less efficient sectors, goes a considerable distance in explaining some of the decline in both aggregate demand and consumption in 2008.
Again, the piece is one of the more accessible and insightful I’ve read on Bernanke in quite a while.
End the Fed: More than Just a Bumper Sticker Slogan?
To put it mildly, the Federal Reserve has a dismal track record. It bears significant responsibility for almost every major economic upheaval of the past 100 years, including the Great Depression, the 1970s stagflation, and the recent financial crisis. Perhaps the most damning statistic is that the dollar has lost 95 percent of its value since the central bank was created.
Notwithstanding its poor performance, the Federal Reserve seems to get more power over time. But rather than rewarding the central bank for debasing the currency and causing instability, perhaps it’s time to contemplate alternatives. This new video from the Center for Freedom and Prosperity dives into that issue, exposing the Fed’s poor track record, explaining how central banking evolved, and mentioning possible alternatives.
This video is the first installment of a multi-part series on monetary policy. Subsequent videos will examine possible alternatives to monopoly central banks, including a gold standard, free banking, and monetary rules to limit the Fed’s discretion.
As they say, stay tuned.
Five Lessons from Ireland
The news is going from bad to worse for Ireland. The Irish Independent is reporting that the Swiss Central Bank no longer will accept Irish government bonds as collateral. The story also notes that one of the world’s largest bond firms, PIMCO, is no longer purchasing debt issued by the Irish government.
And this is happening even though (or perhaps because?) Ireland received a big bailout from the European Union and the International Monetary Fund (and the IMF’s involvement means American taxpayers are picking up part of the tab).
I’ve already commented on Ireland’s woes, and opined about similar problems afflicting the rest of Europe, but the continuing deterioration of the Emerald Isle deserves further analysis so that American policy makers hopefully grasp the right lessons. Here are five things we should learn from the mess in Ireland.
Is the Federal Reserve Heading Towards Insolvency?
A recent statement from the Shadow Financial Regulatory Committee, points out that both rounds of quantitative easing by the Federal Reserve have dramatically altered the maturity structure of the Fed’s balance sheet. Normally the Fed conducts monetary policy using short-term Treasury bills, which allows the Fed to avoid most interest rate risk. In loading up its balance sheet with long-dated Treasuries and mortgage-backed securities, the Fed has exposed itself to significant interest rate risk.
Recall that the yield, or interest rate, on a long term asset is inversely related to its price. So if you’re holding a mortgage that yields 5% and rates go up to 6%, then the value of that mortgage falls below par. The same holds for Treasury securities. I think it is a safe assumption that rates will be higher at some point in the future. When they finally do rise, and if the Fed still maintains a large balance sheet of long-dated assets, those assets will suffer losses.
Of course the Fed is not subject to mark-to-market rules and can avoid admitting losses by holding these assets to maturity. But if the Fed, at some point in the future, wants to fight inflation, the most obvious way of doing so would be to sell off assets from its balance sheet. It is hard to see the Fed engaging in substantial open-market operations without using its long-dated assets. But if it is to sell these assets, it will have to do so at a loss (once again, because of higher rates).
Now the Fed claims to have other avenues by which to tighten, besides open-market operations. For instance, it can raise the interest rate on excess reserves. But then this would further erode the value of assets on its balance sheet. Not to mention that they have to find the money somewhere to pay these higher rates on reserves.
Ultimately the Fed can continue to pay its bills, not out of earnings from its balance sheet, but by electronically crediting the accounts of its vendors and employees, but that would also be inflationary. The real danger, again pointed out by the Shadow Committee, is that the Fed may avoid raising rates in order to minimize the losses embedded in its balance sheet. One of the very real dangers from QE1 and QE2 is that the Fed has exposed itself to potential losses that are correlated with any efforts to fight inflation, raising serious questions as to its willingness to fight inflation.
Bernanke’s Twist on Price Stability
While it’s been obvious for years, Bernanke showed his rationale for more easing in today’s Washington Post. He believes we are in danger of too little inflation. While common sense might imply that price stability means neither inflation nor deflation, in Bernanke’s book, anything below the Fed’s target of 2 percent is bad.
First of all, there really needs to be a public debate over the Fed’s 2% target. After all, a 2% rate of inflation over, say, 30 years erodes almost half of one’s wealth. How that can seriously be viewed as “price stability” is beyond me. While a 2% rate of inflation is not going to bring the economy to a halt, it is still a massive theft of wealth over the long haul.
Bernanke has also expressed the fear that “low and falling” inflation could lead to deflation, which would raise the real value of debt, which could lead to additional defaults. But what Bernanke doesn’t seem to get is that inflation isn’t falling. Let’s go to the data.
The graph below is simply the consumer price index (CPI) over the last year. Does it appear to be falling? Of course not. In fact, the trend is one that is rising.
Now CPI includes lots of things, some of which are temporary trends. The Fed has a nasty habit of excluding those items it doesn’t like. But let’s take a look at something that matter to the typical family: food.
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.
Does High Unemployment Make Inflation Impossible?
Benn Steil and Paul Swartz wrote a technically brilliant yet readable Wall Street Journal tutorial explaining why “the Fed’s exit strategy is not credible, and that means a serious risk of high inflation down the road.”
They are sure to be ignored by those of the Keynesian faith who have repeatedly assured us that inflation cannot possibly be a problem for many, many years. Why not? Because there is so much “slack” in the economy—a euphemism for high unemployment.
If this “slack theory” of inflation makes you too sanguine about future inflation, recall that it is the same theory that predicted stagflation would be impossible in 1973–75 and 1979–81.
Figures from The Economist, August 21, raise some doubts. The latest unemployment rate in Argentina is 8.3%, but CPI inflation over the past year was 12.2%. Unemployment in Venezuela is 8.2%, but inflation is 13.3%. Unemployment in Egypt is 9.1%, but inflation is 10.7%. Unemployment in India is 10.7%, but inflation is 13.7%. Unemployment in Turkey is 11%, but inflation is 7.6%. Wasn’t high unemployment supposed to make high inflation impossible?
Perhaps Slack Theorists might take comfort from the fact that inflation is “only” 4.2% in South Africa, where unemployment is 25.3%. But that is not exactly solid proof.
Whenever Keynesian dogma proves so completely at odds with the facts, there is a powerful inclination among true believers and their herd of media apostles to cling to the theory and diregard the facts.
Some volatile economists who previously worried about near-term U.S. inflation have switched to assuming (as they did in 2003) that high unemployment will produce deflation. Yet that is obviously not happening in the countries listed above. The only country with falling prices is Japan, with an unemployment rate of 5.3% (and foolishly high tax rates and decades of wasteful ”fiscal stimulus”).
File the Steil-Swartz article away for future reference.
And remember Reynolds’ Second Law: “Inflation is always lower before it moves higher.”
Senate Bill Sows Seeds of Next Financial Crisis
With Majority Leader Harry Reid’s announcement that Democrats have the 60 votes needed for final passage of the Dodd-Frank financial bill, we can take a moment and remember this as the moment Congress planted the seeds of the next financial crisis.
In choosing to ignore the actual causes of the financial crisis — loose monetary policy, Fannie/Freddie, and never-ending efforts to expand homeownership — and instead further expanding government guarantees behind financial risk-taking, Congress is eliminating whatever market discipline might have been left in the banking industry. But we shouldn’t be surprised, since this administration and Congress have consistently chosen to ignore the real problems facing our country — unemployment, perverse government incentives for risk-taking, massive fiscal imbalances — and instead pursued an agenda of rewarding special interests and expanding government.
At least we’ll know what to call the next crisis: the Dodd-Frank Crash.
Show Me the Money
A number of economists have been warning about the Federal Reserve’s easy-money policy, but defenders of the central bank often ask, ”if there’s an easy money policy, why isn’t that showing up in the form of higher prices?” Thomas Sowell has an answer to this question, explaining that people and businesses are sitting on cash because anti-business policies have dampened economic activity.
Not only has all the runaway spending and rapid escalation of the deficit to record levels failed to make any real headway in reducing unemployment, all this money pumped into the economy has also failed to produce inflation. The latter is a good thing in itself but its implications are sobering. How can you pour trillions of dollars into the economy and not even see the price level go up significantly? Economists have long known that it is not just the amount of money, but also the speed with which it circulates, that affects the price level. Last year the Wall Street Journal reported that the velocity of circulation of money in the American economy has plummeted to its lowest level in half a century. Money that people don’t spend does not cause inflation. It also does not stimulate the economy. …Banks have cut back on lending, despite all the billions of dollars that were dumped into them in the name of “stimulus.” Consumers have also cut back on spending. For the first time, more gold is being bought as an investment to be held as a hedge against a currently non-existent inflation than is being bought by the makers of jewelry. There may not be any inflation now, but eventually that money is going to start moving, and so will the price level.
I do my best to avoid monetary policy issues and certainly am not an expert on the subject, so I asked a few people for their thoughts and was told that perhaps the strongest evidence for Sowell’s hypothesis comes from the Federal Reserve’s data on “Aggregate Reserves of Depository Institutions” – specifically the figures on excess reserves. This is the money that banks keep at the Federal Reserve voluntarily because they don’t have any better options. As you can see from the chart, excess reserves shot up during the financial crisis. But what’s important is that they did not come back down afterwards. Some people refer to this as “money on the sidelines” and Sowell clearly is worried that it will have an impact on the price level if banks start circulating it. That doesn’t sound like good news. On the other hand, it’s not exactly good news that banks are holding money at the Fed because there are not enough profitable opportunities.
What this really tells us is that the combination of easy money and big government isn’t working any better today than it did in the 1970s.
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