According to Bill Shakespeare (my post-election populist style) “a rose by any other name would smell as sweet.” I’m not so sure. Exhibit A is the current hoopla over QE2, or the Fed’s second round of so-called quantitative easing. The inevitable comparison to a huge ocean liner conjures up images of draconian measures—a monetary policy Hail Mary—likely to accelerate inflation internally and debase the currency externally. I beg to differ.
Those outcomes would result if the Fed overdoes it. But equally bad, and probably worse outcomes—a double-dip recession and possible deflation—would result if the Fed under does it. Does what?
The Fed conducts traditional monetary policy by buying or selling short-term Treasury securities in the open market. Its purchases result in more deposit money in banks and more reserves held by banks at the Federal Reserve. With each dollar of bank reserves able to support about $10 in deposits, banks normally use the excess reserves created to make more loans or investments and create deposit money ten times larger than the Fed’s purchase.
One can say, correctly, that the Fed is creating money in this process. One could even say, metaphorically, that the Fed is printing money. The outcome is a matter of degree. Too much money creation would stoke inflation and likely cause the dollar to decline in foreign markets. This assumes the money is spent internally on goods and services and externally on foreign currencies. Too little money creation would have opposite effects.
If one wanted to call the routine purchases of Treasury securities described above “quantitative easing,” he would not be inaccurate. It isn’t called that normally, however, because the impact on the economy will work partly by expanding the public’s money supply and partly by putting downward pressure on interest rates.
As the storm gathered during 2008, the Fed aggressively eased monetary policy by using such open market operations (supplemented by discount rate reductions) to drive short-term interest rates to near-zero levels. That used up the traditional interest-rate channel of monetary policy, but not the more direct channel of money supply growth. The Fed’s lending during 2008, together with its asset purchases in frozen markets, caused the assets in its balance sheet to increase sharply-- from $800 billion before the crisis to over $2.3 trillion by year-end.
Fed lending and asset purchases on such a massive scale caused equal expansion of its liabilities, most importantly the reserve deposits of commercial banks and thrifts. The expansion of bank reserves normally would have prompted additional bank lending and investing, and thus expansion of monetary deposits. However, the last step in that process was never taken to any substantial extent.
With loan demand from creditworthy borrowers weak during the recession, and banks still suffering from the financial crisis, perverse accounting rules that caused them to lose regulatory capital, and persistent banker bashing from the Administration and Congress, many banks held onto their reserves to cushion further capital losses. People call these balances “excess reserves” because they exceed the levels required by law and regulation, but bankers didn’t necessarily see them as excess. They saw them as needed. The bottom line is that the massive loans and investments made by the Fed did not translate into overly rapid growth in the money supply—a fact not understood or appreciated by those trumpeting the inflation theme.
Despite the widespread slack in the economy, including an almost 10 percent official unemployment rate, money growth has not been overly rapid for the circumstances. M2, the most reliable measure of money, has grown only 3 percent over the past year, while the narrow M1 measure grew only 6.3 percent. Fortunately, those rates have accelerated some in the past three months, but are hardly excessive under the circumstances.
Real GDP growth has decelerated recently, to an annual rate of 1.7 percent in the second quarter and 2.0 percent in the third, with over half of this meager growth—which is true since the recovery began—attributable to inventories.
Employment growth has stalled, with total employment declining for the past four months. Unemployment seems stuck at 9.6 percent. If discouraged workers and others marginally attached to the labor force are included, the unofficial unemployment rate exceeds 16 percent.
Moderate money growth, weak real GDP growth, declining total employment, and persistently high unemployment have driven inflation down, not up. The Consumer Price Index over the past 12 months has increased less than one percent, the lowest in decades. Under these circumstances, at least moderate Fed easing is needed, but it should take place routinely and without fanfare. Instead, excessive hype and public second-guessing by the policymakers have created a crisis atmosphere around monetary policy.
In that regard, I was disappointed of the specific amount and time frame for its “quantitative easing” in the FOMC announcement on Wednesday. I would have preferred the greater flexibility of no announced amounts or deadlines.
Obsessing over inflation while it is falling and while deflation is emerging as a possibility is not helpful. Neither is scare mongering with misleading terms like QE2. I’m afraid the markets, and cable TV viewers alike, have been conditioned to overreact and to fear sensible policies.
As I opined in a recent blog, QE2 was a really big ocean liner; it is not a monetary policy.