The actions of the Federal Reserve have been important news in the last part of 2010 with its current policy of renewed “quantitative easing” (QE2), as well as with the recent publication of documents pertaining to its previous quantitative easing (QE1). These recent actions, especially QE1, are in sharp contrast to prior Fed activity, and raise serious questions about the appropriate role and powers of the Federal Reserve. QE2 is a more traditional monetary expansion, but there are concerns about igniting inflation and whether monetary policy is an appropriate tool for the present economic environment. We relate our discussion to concerns and prospects for 2011.
Traditional fed actions
A primary role of banks in the economy is to coordinate the activities of borrowers and savers. Consumers and businesses deposit funds into savings and checking accounts, and banks, in turn, keep a portion on hand to meet day-to-day transactions (reserves) and lend much of the remaining balances to consumers and businesses that want to borrow. When banks have excess reserves they don’t lend to consumers or businesses, they may purchase Treasury securities or lend to other banks that are low on reserves. Through lending, bank reserves are multiplied into additional deposits so that the “money supply” (currency plus deposits in banks) is a multiple of the “monetary base” (currency plus reserves held in banks). Prior to the financial crisis in 2008, the Fed primarily controlled this money supply and interest rates using open-market operations – the buying and selling of Treasury securities.
Appropriate monetary policy is still debated. One view is that the Fed should engage in “aggregate demand management,” so that if there is high unemployment, monetary policy should stimulate the economy through the expansion of reserves to achieve full employment without igniting inflation. Other views argue that the Fed should have a more modest purview, such as maintaining price stability or supplying liquidity in times of financial market unease when otherwise solvent banks may run short of reserves. Some also emphasize the importance of minimizing Fed interference in the market determination of interest rates. Regardless of the Fed’s policy orientation, its actions in the past have largely taken place through open-market operations.
At the onset of the financial crisis and the slowing of the economy, most agreed that the Fed should inject liquidity into the market, i.e., engage in “quantitative easing.” However, the Fed did so in a highly unusual way and went well beyond straightforward monetary expansion.
Under normal monetary expansion, the Fed purchases Treasury securities from banks, which provide them more loanable reserves. But during the crisis, the Fed also initiated many short-term liquidity and credit programs where borrowers were allowed to put up a variety of debt obligations as collateral, including mortgage-backed securities of unknown value. In effect, the Fed put reserves into banks by purchasing a grab bag of securities, many of which likely were bad assets. Additionally, the Fed began making loans not only to banks but government-sponsored agencies, nonbank financial institutions, foreign banks and nonbank entities.
Moreover, unlike funds available through TARP (Troubled Asset Relief Program), borrowers through these facilities were not subject to direct oversight by Congress. The original intent of TARP was for the Treasury to buy troubled assets. Treasury gave up on this approach, but the Fed did it instead.
According to the Fed, its short-term liquidity and credit programs fell “into three broad categories – those aimed at addressing severe liquidity strains in key financial markets, those aimed at providing credit to troubled systemically important institutions, and those aimed at fostering economic recovery.” The second category – providing credit to troubled institutions – is highly unusual. In fact, this is bailing out insolvent institutions.
Though the Fed did succeed in increasing liquidity in the market, much of its “quantitative easing” was offset by other actions. An important measure was the Fed’s initiation of paying interest on banks’ excess reserves and suggested long ago as an alternative way for the Fed to manage banks’ reserves. Instead of requiring minimum reserves, the Fed could induce more or less reserves by moving the interest rate it pays up or down. In 2006, legislation allowing the Fed to pay interest on reserves and to reduce the reserve requirement to zero was passed. Implementation date was moved up to Oct. 1, 2008 by the Emergency Economic Stabilization Act of 2008.
The initiation of payment on reserves (with no change in reserve requirements) naturally induces banks to hold more reserves, reducing the money supply. The Fed’s purchases of an assortment of securities expanded the volume of banks’ excess reserves to unprecedented levels. However, the money supply did not expand proportionately, in part due to the payment of interest on these reserves. Thus, one aspect of “quantitative easing” was not about increasing the money supply. The Fed acquired mortgaged-backed securities from banks in exchange for interest-bearing reserves.
Another offset to the expansionary nature of QE1 was the U.S. Treasury’s Supplementary Financing Program. Under this program, the Treasury sells securities to the public and supplies the proceeds to the Fed to either lend or hold. Because the action by the Treasury removes banks’ reserves, this allows the Fed to buy troubled assets without creating new reserves. Therefore, this activity of the Fed is not an effort to increase the money supply.
The Fed has been quite successful in removing many mortgage-backed securities off of banks’ books. Until 2008, nearly all its assets were Treasury securities. However, by late 2009, its holding of mortgage-backed securities outstripped that of Treasuries.
Many economists (including the authors) are concerned that these newly exercised powers of the Fed puts more discretion in the hands of the Fed and subjects it to more political pressure in allocating credit as opposed to letting markets decide winners and losers. The Fed’s targeted lending activities included not only nonbank financial institutions such as AIG, Fannie Mae, Freddie Mac, Bear Stearns and central banks, but also such “systematically important institutions” as McDonald’s, Harley-Davidson and Toyota.
Economist James Hamilton views this new authority of the Fed as a potential threat to Fed independence: “The decision of where public funds are best allocated is inherently political. Any risks on the Fed’s new balance sheet are ultimately borne by the taxpayers. … The Fed is simply being naive if it thinks it can become involved in those decisions on a weekly basis and yet still retain its independence.”
Despite the actions taken in QE1, the economy remained sluggish with high unemployment, and banks continued a reluctance to engage in more lending. Demand for lending declined as well. Thus, the Fed decided to engage in a second round of quantitative easing.
The Fed’s goal with QE2 is to spur the stagnant economy and is expected to be closer to traditional monetary policy, with a slight variation. Instead of focusing on open-market purchases of very short-term Treasury securities, the Fed will purchase $600 billon of longer-term securities. Because short-term interest rates are so low, the Fed can do little to lower them more, so it is moving to reduce long rates. This may be viewed as the Fed using the last possible weapon in its arsenal. To this point, there has not been much
An obvious question is whether these actions will stimulate the economy and/or generate inflation. Traditional management will stimulate aggregate demand. The problem is that the Fed cannot force banks to lend or consumers and businesses to borrow. However, if the economy finally invigorates, and consumers, businesses and banks become emboldened, then there could be significant inflationary pressure as the reserves created in QE1 and QE2 are lent out. To prevent that, banks must be induced to hold on to many of those reserves. The Fed believes that it can do so in a timely way by raising the interest rate it pays on reserves. Unfortunately, there is no evidence to suggest that the Fed can steer the U.S. economy with such precision. A harsh reminder is the steep tightening of the Paul Volcker-led Fed in the early 1980s. The Fed pushed the targeted federal funds rate in excess of 19 percent, leading to a sharp recession.
Where do we go from here?
Given this flurry of unusual activity by the Fed over that past two years, what is the outlook for 2011? An important issue to consider is whether activist monetary policy is critical to economic recovery. It seems that the main problems of the U.S. economy today are not related to liquidity, but to the real return on investment and productive activity. Right now, it is uncertain with a low expected value. The reasons for this have been discussed widely: uncertainties and concerns about future income tax rates, the cost of healthcare reform, the prospect of higher energy costs, increased lending costs due to the financial reform bill, and a growing federal debt.
None of these concerns is alleviated by expansionary monetary policy. Until these fundamentals are addressed, we are not sanguine about a robust recovery developing in 2011.
One of the lessons from the 1970s stagflation was that quantitative easing cannot “buy” lasting economic strength and ultimately leads to inflation. Another lesson was that it is difficult to fine tune the economy and efforts often go awry. The prospect of Fed attempts to engage in fine tuning, rather than focusing on price stability, give us more cause for caution in looking to 2011.
Long-term, we are also concerned about the role the Fed has taken on in QE1 – acquiring sketchy assets, bailing out insolvent institutions and discretionary use of Treasury funds. The Fed taking on these powers and its collaborative actions with Treasury suggests a creeping political influence and lack of independence. Fed officials staunchly defend its independence, but their own actions have undermined it. A politicized Fed will surely lead to politicized investment, with the associated low returns and stagnant economic growth.
Should Fed powers to intervene in financial markets be trimmed? We argue that it is better to undertake policies that lead to more stability in the first place (e.g., no government encouragement of high-risk real estate loans, efficient bankruptcy procedures to deal with insolvency). These obviate the necessity for a powerful government entity to come to the rescue and also prevent the concentration of political and economic power into the hands of the few.