A Toxic Phrase for a Routine Policy
When the Fed “eases” monetary policy by stepping up its purchases of government securities,bank reserves and deposits usually expand by the amount of the purchases, and, because of the fractional reserve system, further multiple expansion of bank credit and money ensues. This process is also usually associated with downward pressure on interest rates.
Some people focus on the expansion of bank credit, some focus on what happens to interest rates, and some focus on the growth rate of the money supply. Most academic economists, following the lead of Milton Friedman, focus on money growth as the main measure of the stance of monetary policy, even if the Fed’s short-term operating strategy targets the Federal Funds rate.
No matter what the specific focus of attention, however, all these factors are part of normal monetary policy. To stimulate a weak economy, the Fed steps up its open market purchases. To cool an overheating economy, the Fed will likely slow its open market purchases. In the very short run it might even sell government securities, but open market sales and money shrinkage would be too harsh a medicine to go on for very long.
My point here is that open market purchases and the associated expansion of money growth rate are accepted as normal or routine Fed policy so long as interest rates have some room to decline in the process. That the Fed creates money by its open market purchases is not considered an issue if interest rates can be the focus. It becomes an issue only if money creation is too rapid, threatening a buildup of inflation, or too slow, threaten recession. The issue is not that the Fed creates money with open market operation. The issue arises only if it creates too much or too little.
If short-term interest rates (primarily the target Fed-Funds rate) are close to zero the impact of more bank credit and more money creation through open market purchases remains. However, without an associated further decline in interest rate, the impact of further monetary ease will likely still be positive, but less so. Yet, pundits seem to think that monetary ease without the contribution of lower interest rates will be greater, not less. They pin the label of “quantitative easing” on it and complain that the Fed is printing money or debasing the currency. Again, the impact of such “quantitative easing” will probably be less that it would have been had interest rates been in a position to decline further. In other words, so-called quantitative easing probably has less simulative punch than routine easing.
When the Fed engages in open market purchases of government securities (or anything else for that matter), it creates new money whether interest rates are high or low. The relevant question is not whether the Fed creates money, but how much is it creating. Too much is bad; too little is bad. However, the use of the term “quantitative easing,” given its popular association with printing money or debasing the currency, spooks markets. Central banks create money; that’s what they do. Call it printing if you must. Again, though, the question is not whether, but how much or how fast.
Under current circumstances, moderate positive money growth is needed. Stopping the shrinkage by replacing MBSs running off the Fed’s portfolio with Treasuries was a necessary step, but probably not sufficient. I hope the Fed doesn’t let popular misunderstandings associated with toxic terminology keep them from doing what is necessary sooner rather than later.