Econ Matter: What is the Fed doing?
By the end of the second quarter of 2011, the Fed intends to buy $600 billion of Treasury Department securities, especially those at the longer end of the maturity spectrum, to help the US economy.
By bidding up prices of long-term Treasury bonds, interest rates on debt will fall. Rates on other long-term instruments, such as mortgages and corporate bonds, will be low enough to entice people to buy new houses and borrow for big corporate projects.
The size of this round is not unprecedented. Between September 2008 and April 2009, the Federal Reserve was a net purchaser of securities. By the time this round was complete, the Fed had injected roughly $925 billion of base money into the US economy.
There is an important difference between the 2008-2009 money-expansion episode and this one. In 2008, it was becoming clear that the banking and payment system was under significant duress. The Federal Reserve, in its role as lender of last resort, was the perfect agency to offer much-desired liquidity to the financial system.
Indeed, I am a big cheerleader of this action. If the payment system had frozen, the Great Depression, in my view, would have looked like a walk in the park. We take for granted our sophisticated, well-functioning payment system. Without it, you and I might have been temporarily bartering economics lessons for home-grown vegetables. (I would have lost some weight, I suspect.) Rather, the Federal Reserve stepped in and offered base money to banks and other financial institutions.
How did the Fed’s first round of money expansion affect our economy? Milton Friedman told us that inflation is always and everywhere a monetary phenomenon. When the US money supply doubled, the prediction would have been that higher inflation rates are imminent. Yet, where is the predicted inflation? One is tempted to answer with Friedman’s other dictum that there is a long and variable lag between monetary policy actions and the effects. In my view, there is another explanation: The demand for base money increased by as much as the supply of base money. Hence, there was no increase in inflation rate pressures building.
Bernanke is not surprised by the absence of any uptick in inflation. Indeed, he based his research on the Great Depression and would argue that deflation — that is, falling price levels — is the real concern in the US economy. There are two possibilities: one is that deflation is a symptom of an economy that is contracting; the other is that deflation causes weak economic conditions as people want to hold money as a store of value rather than make loans to finance investment purchases. This distinction matters. If deflation causes a weak economy, then avoiding it is useful. In contrast, if deflation is a symptom, then expanding the money supply might not solve any of the underlying economic condition
The problem facing the Fed’s actions are twofold. First, this round of quantitative easing is not likely to stimulate the US economy. As Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, put it, the problems in the labor market are not problems that monetary policy is particularly good at repairing. In addition, equipment and other capital good purchases are low because the returns to such activities are presently low. So the traditional monetary policy channels are not operational.
Second, the US appears to be in a liquidity trap. This means that interest rates are so low that any additions to the supply of base money will simply be held as cash by financial institutions. The point is few viable alternatives exist. Banks make money by lending funds at higher rates than they pay to obtain the funds. At present, cash reserves are offering a safe return compared with the alternatives. This will not always be the case. When productivity gains begin to emerge, and bankers and others identify credit opportunities that are worth taking, then we will see a reduction in the demand for base money. Unless Bernanke can quickly reduce the supply of base money, we will see higher inflation.
In the end, Bernanke will be able to say that he tried to use the tools available to the central bank to stimulate the economy. His gamble is that he and his fellow central bankers can sell enough Treasury securities to shrink the supply of base money in time to avoid a run-up in inflation. If they pull this off, Bernanke would be, in my view, the greatest central banker of all time.