Enough With Calling For More Fed Action Already

by: Rogue Economist

Operation Twist. There goes the Fed again with its endless bag of tricks. QE2 did not work as expected. Now the Fed hopes the Twist will do the job. The ironic thing is that for the past two years, Bernanke himself has been saying that the government needs to undertake more fiscal policy. Read between the lines, and you'll see that he is already very reluctant to do more on the monetary policy front as it just introduces more complications to an already fragile economy, leads to more malinvestment, more market uncertainty, without achieving its real aim, which is to encourage more economic activity. At this point, the Fed is doing the Twist likely only to promote the perception that the Fed is doing something.

Monetary easing is a potent economic weapon, and just like an atom bomb, it doesn’t make a distinction of who it targets. It doesn’t care whether you’re rich or poor, whether you’re a consummate saver or you’re a consummate debtor. Monetary easing will always have one effect on you – take on more risk. Many monetarists who subscribe to the beneficial effect of monetary easing are blindsided by the debt problem. Many people who subscribe to monetarism don’t believe in the existence of banks or debt, and think that increasing the money supply automatically results in a higher price level. Those who do believe in the existence of banks think that banks automatically lend what funds land in their laps without consequence. And that they can just find additional capable borrowers out on the street like Mcdonalds (NYSE:MCD) finds new patrons for new stores.

Monetarist proposals ignore Debt's downside effects on economic agents, while over-estimating easing's effects on inflation expectations. But debt does make a difference -a very large difference. Inflationary measures can be hindered in a recession economy with a lot of debt, because the indebted who are undergoing deflation, i.e. balance sheet recession, will not be induced to make more purchases if paying off the debt is already eating up much of their income. Monetarists hope that the non-indebted ones will come to the economy's rescue, and be induced to consume more, because of increased inflation expectations (they will consume now before prices get more expensive). But then, the non-indebted have to first be convinced that the ongoing balance sheet recession among the indebted will not counteract any of the inflationary measures. Thus far, nobody's convinced. Not in numbers big enough to achieve what monetarists want. The question is, should the Fed be ready to do whatever is necessary to move everyone's expectations? What are the unintended consequences of printing whatever it takes to move everyone's expectations? (Of course I say no, and have said so here, here, and here).

Indeed, Fed policy has come down to managing expectations. And it’s all about the expectation that everyone’s expectations will be as the monetarists expected (pun intended). Just like people who try to drive their cars by only looking at their rear view mirror, monetarists believe that the Fed can run the economy by looking at the stock/asset markets. Yet the monetarist view is so widely held by many economists that several have proposed changing the Fed's charter and increasing the Fed's powers to be able to invest not just in government bonds, but also in private sector corporate bonds and equities. All this talk of the Fed using unconventional monetary policy tools has had the effect of making many economists propose even more far out Fed actions than its charter already allows.

But is this a good idea? Should government be allowed to buy corporate stocks and bonds? Assuming that central bankers are allowed to buy stocks, why consider only select companies in the S&P 500 (NYSEARCA:SPY)? Why create an uneven playing field by giving these already large publicly listed companies a lower cost of capital over other companies? Why not issue new money to fund new ventures instead? After all, small businesses not listed in the stock market probably have better prospects for growing the economy, and returning better yields to government, no? And if these small businesses fail, the act still boosted money supply going around in the system, which is the intention (of this proposal) anyway. Government getting into the public stock market only rigs the stock investing game more than it already is.

Throughout its existence, the Fed has had an escalating mission creep. It started with merely being the lender of last resort, to help banks undergoing liquidity problems. Then it was given the dual mandate of price stability and controlling unemployment. It therefore now uses its rate-setting power to control economy-wide inflation, control aggregate employment, control system-wide bank lending, and control over-all asset speculation. As a secondary effect, its power has had control of the stock and bond markets, and therefore it has control of industrial policy.

The Fed has control of the currency's value, and as the issuer of the global default currency, therefore controls international capital flows and international trade flows. It therefore has indirect control of foreign countries' monetary policy, and therefore indirectly controls foreign inflation, controls foreign stock and bond markets, controls foreign industrial policy and other countries' experience of international flows. If we increase the scope of its mandate, who knows what secondary effects are next?

If we allow the Fed to invest in corporate bonds and equities, where does Fed intervention end? If the Fed's charter is further increased, the Fed may just as well dictate who people marry, and how many children they sire. After all, these decisions have economic repercussions, right? Allowing more kids is easing, restricting having them is tightening. Is this where all this is heading?