We’ve been conditioned by numerous post-FOMC press releases to expect a continuation of near-zero target Federal Funds rates for an extended period. Unfortunately, that “promise” means that it has to be withdrawn before a modification can be made—else it becomes a broken promise. I say unfortunately because the time has come to increase the rate target by a nominal amount to begin reducing the distortions such an artificial rate causes in financial markets. One-half percent or three-quarters percent isn’t high by any means, but it would be a useful signal of the beginning of normalcy. Besides, bank deposit customers need some relief.
Meanwhile, what came to be called—unfortunately in my opinion—QE2 was begun with an announcement of a specific amount of $600 billion and an end date of June 30. Consequently, it has been taken for granted that the natural order of things is for QE2 to be ended, replaced, or modified well before the end of near-zero Federal Funds sometime late this year, next year, or the year after. QE2 has been so maligned and has become so unpopular that it can’t be replaced by something that can be called QE3, but neither can QE2 be dropped cold turkey without some reassurance that the FOMC won’t let the money supply fall off a cliff. “Vigilance” will have to be promised, however it is described.
I think the expected and likely sequence of these two events is backwards. An abrupt end or substantial curtailment of QE2 is more likely to roil the financial markets and threaten renewed economic weakness that is a slight increase in the target Federal Funds rate. Since one is a quantity (of money) goal and the other is a rate (of interest) goal, some fine tuning should be possible. If I were still on the Committee, unless I had information I don’t have and can’t imagine now, I would argue for relief on rates prior to any substantial end to quantitative easing. Without the inhibiting language in the last statement, I would argue for the rate relief at the next meeting.
I have noticed that the tone on Financial TV has shifted lately regarding QE2 from “it will lead to hyperinflation” to “can the financial system survive its end?” Perhaps—but likely not—that’s because some people finally looked at the money supply figures and belatedly realized that QE2 has not produced an explosion of money—bank reserves, yes, but not money.
M2 growth over the past year, the past six months, and the past three months has ranged from around four to five percent. That’s hardly a hyperinflation growth rate, especially with the unemployment rate above nine percent most of that time. It has taken an extraordinary effort by the Fed just to make money grow modestly under the circumstances. Less aggressive open market purchases would have left money growth in negative territory.
Anyway, it’s now more important to keep money growth positive but modest than it is to keep short term rates near zero.