In my previous article, I noted that the FOMC has apparently begun to think of its low interest rate policy and its quantitative easing/balance sheet expansion policy as two different things. Its latest minutes suggest sentiment by some members for slowing or ending the announced open market purchases by the end of 2013, or possibly even sooner. There was no suggestion, however, that doing so would bring its accommodative monetary policy (low interest rates) to an end. I suggested that, if those two things can be treated separately, then it would be better to do the opposite: allow interest rates to rise a bit while keeping quantitative easing adequate to provide continued growth in the money and credit aggregates. The latter would continue support for the fragile economy, while the former would provide relief for savers who have suffered minimal interest rates for over four years now.
I later realized that my suggestion for keeping QE active enough to support the economy highlights a difference in the way I’ve always thought about monetary policy and the way Chairman Bernanke thinks about it. Using the equation of exchange (MV = PQ) as a framework, the way I learned it was that to keep P (the price level) relatively constant, you need MV to grow at about the same rate as Q (real output) is capable of growing. Faster risks inflation; slower risks deflation or recession. If V (velocity of money), which is a reflection of the demand to hold money balances, is stable, then the growth in M should match the potential growth in Q. If V is not stable, but is predictable, then M growth can be adjusted to accommodate V’s change. The bottom line is that to keep the real economy growing at or near its potential money should grow at about the same rate. Precision is unlikely, but at least money needs some growth to prevent a drag on real growth.
The implication of my view of the way monetary policy works for the assets of the Fed is that the current level of total assets is a result of past policy and that continued slow growth is needed to support the real economy going forward. Obviously, if banks start utilizing their excess reserves more aggressively to make money-creating loans and investments too rapidly, then partially offsetting open market sales would be needed. Likewise, if the velocity of outstanding money picks up substantially, a similar offset may be needed. However, if neither of these things happens, I see no reason to stop open market purchases entirely. To do so would represent a sharp tightening of monetary policy.
That, however, is not the way Chairman Bernanke views the role of the Fed's balance sheet. On many occasions, he has said that it is the level of the assets on the Fed's balance sheet that determines the stance of policy rather than their rate of growth. Consequently, he believes (as I interpret him) that, if the balance sheet stopped growing at some point, the existing degree of ease at that point would continue. He apparently does not believe, as I always have, that a flow of new money is necessary to sustain real growth as long as the stock of money doesn't shrink. He believes that the size of the Fed's balance sheet is what's important. I don't understand his reasoning, but I freely acknowledge that he is not only smarter than I am, but that he is much more familiar with recent literature on the subject. His views have been aired among high-level academics at Jackson Hole among other places and survived.
My point in bringing this up is that it does lend credence to the idea that the FOMC may slow or stop growing the balance sheet sooner rather than later. The Chairman, for one, would not consider that a tightening of monetary policy, especially if interest rates remained low. That does not change my view that if QE and interest rate management are separate things, it would be better to give savers some relief by allowing interest rates to rise a bit. It is helpful, however, to get over the idea that interest rate targeting precludes a range of possibilities in open market operations.