How the Fed Should Operate in Treacherous Waters
Thursday, March 17, 2011
Federal Reserve Chairman Ben Bernanke would be wise to learn from the Titanic and slow his second experiment with quantitative easing, the expansion of the central bank’s balance sheet known as QE2.
Ever since the Titanic sank 100 years ago, historians, both academic and armchair, have re-run the events leading to the tragedy. Better rivets, efficiently filled lifeboats, and more alert radio operators would have helped. But the most compelling explanation is also the simplest: Expect a more favorable outcome when a ship steaming into treacherous waters goes more slowly. A cautious pace allows the crew time to identify hazards and limit the damage from those that cannot be avoided.
This basic lesson of history from the North Atlantic is going unheeded by Federal Reserve Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee (FOMC). On March 15, they issued a statement that their ongoing second experiment with quantitative easing, the expansion of the central bank’s balance sheet known as QE2, would continue full-speed ahead. A prudent course would have been to slow, but not stop, QE2.
For the past three years, Captain Bernanke and his crew have mostly fretted about downside risks to economic activity and the possibility that inflation would get too low. Those worries led them to launch QE2 in November and plan to purchase a net $600 billion of Treasury securities by June.
QE2 was meant to spark a more appropriate attitude toward risk-taking as the proceeds from Fed open-market operations left burning holes in investors’ pockets.
Open-market purchases at that pace were supposed to lift financial markets and the economy through three main channels.
First, through the magic of modern central banking with a fiat currency, those asset purchases are paid by electronic entries creating bank reserves. In principle, jacking up reserves to their current lofty level of $1.25 trillion should encourage banks to lend more in support of spending.
Second, for most of last year, Fed officials believed that equities were seriously undervalued, given earnings prospects and the prevailing low level of short-term interest rates. They hoped QE2 would spark a more appropriate attitude toward risk-taking as the proceeds from Fed open-market operations left burning holes in investors’ pockets.
Third, QE2 was designed to flirt, perhaps flagrantly, with central-bank disaster. Vastly expanding the Fed’s balance sheet might convince the public at large that inflation was headed up, not continued down. As a consequence, the real interest rate—or the nominal federal funds rate stuck at zero minus expected inflation—would fall so as to support spending, encourage the dollar to depreciate, and increase commodity prices.
QE2 was designed to flirt, perhaps flagrantly, with central-bank disaster. Vastly expanding the Fed’s balance sheet might convince the public at large that inflation was headed up, not continued down.
So far, the Fed’s batting average is one-for-three, the best that can be expected from a major league player but disappointing from, say, a cardiovascular surgeon. Banks are already stuffed to the gills with reserves, and nonfinancial firms have $2 trillion in cash parked on their balance sheets. The reserves added in QE2 are not being used. In contrast, the local low point in equity prices occurred at the end of August, when Chairman Bernanke set QE2 to sail. Since then, equity wealth has risen 25 percent. Recent news suggests that this equity market gain is buoying spending, and that increased prices of energy and other commodities are feeding through to headline inflation. This implies the mission has accomplished its third goal of generating inflation—and even surpassed it. The latest three-month change in consumer prices clocked in at an annual rate of 3.875 percent.
For each of these channels, there is a key question about near-term economic prospects.
Is the vigor of incoming readings on the economy evidence of sustained expansion or the product of a quick hit of monetary and fiscal stimulus? Was it the announcement of QE2 in August or its steady application through Treasury purchases over the past few months that supported the ongoing equity market rally? Do recent higher rates of consumer price inflation draw a line under the worrisome prospect of disinflation or mark an even more worrisome resurgence of rapid price growth?
Is the vigor of incoming readings on the economy evidence of sustained expansion or the product of a quick hit of monetary and fiscal stimulus?
The honest answer to these questions is that no one knows for sure, not least those sitting in the Fed’s marble palace. And the prudent response to such uncertainties is: go slowly. If the QE2 were to slow to one-third the current speed, the Fed could stretch out Treasury purchases of $25 billion per month through the rest of the year. If its initial call on the economy proved correct, an attenuated execution should not make a difference because investors would still expect $600 billion of riskless Treasuries to be bought. But if the economy flags in the second half of the year, it will be far easier to scale up QE2 than launch the new QE3. And if oil and other commodity prices keep rising and trigger core inflation, QE2 will meet a quick and icy end. It would be best that when that time comes, there had been a smaller net addition to the Fed’s balance sheet.
The FOMC decision gives us an opportunity to take the measure of the man at the helm. Captain Edward Smith of the Titanic stares back from pictures as a competent man whose whitened beard heightened his gravitas. Still, he is remembered for going too fast. The Fed chairman would have been wise to convince his colleagues to scale back monthly purchases of Treasury securities. There is still time, but the water is getting colder.
Vincent Reinhart is a resident scholar at the American Enterprise Institute.
FURTHER READING: Reinhart considers “Auditing the Fed,” says we have been “Getting Lehman Profoundly Wrong,” and suggests “Setting the Table for Fiscal Restraint.” He also discusses “QE in Theory—and Practice,” reviews “A Year of Living Dangerously: The Management of the Financial Crisis in 2008,” and makes “The Case for Quantitative Easing.”
Image by Rob Green/Bergman Group.