Monetary Policy Easing is Nothing to Fear

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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 hoopala over QE2, or the Fed’s second round of so-called quantitative easing. The inevitable comparison to a huge ocean liner congers 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 with 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 translated 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 in Tuesday’s FOMC announcement Wednesday of a specific amount and time frame for its “quantitative easing.” 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.

Comments (9)

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  1. Bob Reich says:

    I want to believe what you say regarding inflation, Bob. But how do you explain the huge price increases in commodities, including gasoline, that we are seeing today?

    This is from the National Inflation Association’s website.

    “As highlighted in NIA’s new documentary ‘End of Liberty’, which just surpassed 170,000 views in three days, prices of nearly all agricultural commodities have been spiraling out of control in recent months just in anticipation of today’s quantitative easing announcement. In the past 60 days alone, cotton prices are up 54%, corn prices are up 29%, soybean prices are up 22%, orange juice prices are up 17%, and sugar prices are up 51%. Meanwhile, the Dow Jones has only gained 9%.”

  2. Brian Williams. says:

    Does Glenn Beck read your blog? He should.

  3. Al Farragosa says:

    A nice article by Jason Zweig in the Saturday WSJ about a now obscure economist, Melchior Palyi, who, according to Zweig, doubted quantitative easing starting back in the 1930s. Doesn’t necessarily refute today’s actions, but an interesting read nonetheless. Al F.

  4. Ivan Grazhdanin says:

    Great article! Of course, the biggest worry I read in this is the Fed implementing this strategy “just right.” Goldilocks comparisons notwithstanding, the one criticism I would have of the Fed is the lack of restraint at the proper time. Of course, the risk of doing nothing far outweighs your recommendation. Bon chance, America! IG

  5. Mike Durante says:

    Brian Williams is right about Beck. He’s no student of central banking, a common problem among puritan libertarians. Bob Reich is missing the point on commodities. They are rising out of insatiable demand NOT for utilization, but rather for speculation.

  6. Scott Robnett says:

    You can all worship at the altar of the Federal Reserve if you want. Naked printing to pay the debts of a Republic is nothing more than a default of the debt or an inherent tax upon the people of the country thru devaluation of its currency.

    Trust me on this – it will not end well. And as for commodity prices rising on speculation, you’re damn right that’s the reason. But without the QE you would not be exposed to this speculation.

  7. Michael Wilson says:

    I think QE2 should be renamed: Titanic. This is the continuation of a disastrous policy for this country. If we needed some easing, why not feather the throttle a bit, instead of flooring it as the Fed did last week. It will all have to be paid for and the iceberg is going to hurt.

  8. Bob Reich says:

    With all due respect Mike Durante, you are not correct. Food prices including coffee, sugar, wheat and corn are up by HUGE percentages over the past four months. The USDA just also warned that yields on many American-grown crops are going to be down this year. On top of that we are WASTING huge amounts of feed corn to the BS production of ethanol. Food is becoming scarce (and therefore inflated in price) because of lack of production and increase in demand. Speculation may play a role in the increase in price in oil, but not in precious metals. Gold and silver are being bought and hoarded by investors who feel that the dollar will be worthless due to bankers like Mr. McTeer who formerly drew a paycheck from the Federal Reserve.

  9. nikkilarsson says:

    It is really a wonderful article. Good information in terms of monetary policy, quantitative easing and all the works under Fed reserve.