The Federal Reserve Board today announced the introduction of yet another hyper-aggressive monetary policy, dubbed “QE4” by some for the fourth round of quantitative easing. Three times a dud, fourth time a charm? Not likely.
The Fed’s concerns for the economy are well-founded. The economy continues to struggle badly under President Obama’s economic policies of deep uncertainty and high regulations, and it threatens to get worse as the President plays a dangerous game with the fiscal cliff.
As long as inflation remains contained (it is), and as long as there appear to be no unfavorable long-term side effects (oops), it is reasonable for the Fed to be as aggressive as it knows how to try to stimulate the economy.
And thus, QE4. Previously, in QE3, the Fed vowed to buy $40 billion a month in mortgage-backed securities, and in Operation Twist, it vowed to exchange short-term Treasury securities for long-term securities. In its latest move, the Fed will now also buy $45 billion a month in long-term Treasury securities.
Moreover, it has committed to maintaining at least these policies until the unemployment rate falls to 6.5 percent or inflation rises above 2.5 percent. (Under the White House’s most recent rosy forecasts, unemployment does not fall to 6.5 percent until 2015.)
The Fed has resorted to quantitative easing because traditional monetary policy involving the Federal Funds rate is now irrelevant. Once the Funds rate dipped essentially to zero, traditional monetary policy ceased. Quantitative easing essentially tries to push down long-term interest rates as opposed to pushing down very short-term rates, which is the focus of traditional policy.
So far, so good. But the 10-year Treasury rate has held at or below 1.7 percent since early summer. This is about equal to the inflation rate over the past year, suggesting a zero real (inflation-adjusted) interest rate. According to monetary policy textbooks, this should be awesomely stimulative, yet the economy continues to languish. Whatever effect the Fed’s new purchases of long-term Treasury bonds will have on interest rates—and the effect is likely to be very small—the positive effects on the economy will surely be insignificant.
And what are the risks from QE4? The first risk obviously is that inflation may pick up quickly. Some argue that this is unlikely because there is too much slack in the economy, as evidenced by the high unemployment rate. Those making this argument echo a similar refrain from the 1970s. They were wrong then (the unpleasant term “stagflation” was created during this time), and they could well prove wrong again. Economic slack is no defense against strong, sustained inflationary impulses. Thankfully, inflation remains tame—for now.
A second risk arises from the amazing expansion of the Fed’s balance sheet since 2008, which now accelerates under QE4. Some day the Fed will have to unload all the bonds it is buying. When it does, the Fed will be pushing up long-term interest rates. The Fed is pushing on a string today and will be yanking on a taut rope tomorrow.
Can it be done safely? Of course. But it has never been done before, and serious doubt is the only reasonable attitude. The consequences of failure could well be to hold the economy at below-par growth for many years as the Fed’s bond sales artificially elevate long-term interest rates.
In short, the Fed’s concerns about the economy are well-founded. But our troubles are not monetary, but fiscal and regulatory in nature. There is only so much that sound monetary policy can do, and little that even radical monetary policy can hope for. The risks are substantial, the gains minimal.
We won’t know for some years whether QE4 or its predecessor policies will have been worth it. We won’t know until the Fed is forced to unwind all its current activities. Then and only then will we know for sure whether Ben Bernanke’s Fed deserves praise or pillory.