First, it’s time to address the term “Quantitative Easing” once again. It originated when the Fed pushed its target federal funds rate down to near zero, and people said, that’s it. That’s all the arrows in the Fed’s quiver. No, even after short-term rates reach bottom, you can still add to the quantity of money and the quantity of credit and the quantity of bank reserves. After all, followers of Milton Friedman, like me, always thought of monetary policy in terms of the quantity of money rather than interest rates. So, quantitative easing was different from interest-rate easing.
They really didn’t talk about QE1 until we had QE2. I thought QE2 was a terrible label because it reminded people of a humongous ocean liner—it was a really, really big hairy deal. It may have grown into one, but at first you could simply think of quantitative easing as normal open market operations. Before the financial crisis, the Fed conducted monetary policy through open market operations. To ease, you bought more Treasury bills in the open market to make money and credit grow faster and to place downward pressure on interest rates. To tighten, you did the opposite. QE was no different, except later when its scale grew.
We have not had constant, uninterrupted QE. After QE2, we had about 18 months of operation twist when open market purchases of longer term securities were offset by sales of shorter maturities with no net change in the Fed’s balance sheet. QE3 started in September 2012 and is just over a year old. But during this past year, Quantitative Easing ceased being about quantities and became all about longer term interest rates. The quantity of money is hardly ever mentioned, even by the Fed. And while the Fed’s balance sheet approaches $4 trillion in assets (and liabilities), the money supply has increased at only a moderate rate given the circumstances of the economy.
The best analogy I’ve come up with is the Fed is peddling a bicycle in a very, very low gear. It has to peddle like crazy to achieve enough speed to keep the bike from tipping over. The M2 measure of the money supply has grown roughly 7 ½ percent per year in recent years. The income velocity of M2 has declined roughly 3 ½ percent per year, for a net spending (nominal GDP) increase of 4 percent per year. That 4 percent nominal spending or GDP growth has translated into roughly a 2 percent real growth rate and a 2 percent inflation rate.
Critics of QE promised hyper-inflation and a collapse of the dollar resulting from such money printing. But money printing was very muted. The securities purchases increased bank reserves and deposit money, but the multiple expansion of deposit money in a fractional reserve system didn’t take place. Banks added to their excess reserves rather than maximize the lending and investing they could have done on the basis of their new reserves. The same thing happened in the Great Depression and for the same reason. There was too much uncertainty and danger facing banks, and their reserves were excess in a regulatory sense but not in their own minds. It doesn’t really change anything that banker caution probably was more focused on their capital position rather than their reserve position.
The hoarding of excess reserves limited the money creation or “printing” that took place despite the Fed’s massive purchases of securities and expansion of its balance sheet. That’s why the dire consequences predicted never came to pass. However, it is also the reason that the Fed’s purchases never stimulated the economy as much as hoped.
Some critics—fewer since people have come to like the impact of QE on stock prices—claim that QE is a failure and should be ended because it has been doing little good. My thought has been that we must consider the counterfactual. If hard peddling was necessary to keep the bike (economy) moving slowly, then surely it would tip over if the peddling stopped. What do you do if you lead a horse to water but he won’t drink? Throw the water out or spike it?
Of course, I think I’ve been right on this issue. However, the passage of time has been wearing on me. Two percent economic growth is way too low and seven percent unemployment is way too high, but both those things are looking more normal than they used to. Slow growth is inevitable when the labor force participation rate keeps shrinking along with the employment population ratio. Productivity growth has slowed in the past two years, but it will probably bounce back. However, the reduction in the number of people working seems more lasting. QE this past year has helped keep longer-term interest rates lower than they would have been otherwise. But lower long term interest rates is a two edged sword. It helps some and hurts others. Low returns on savings have always been a feature of an easy money policy, but easy money policies have always been short-lived. This one is beginning to look permanent. I’m beginning to wonder if us people with savings accounts in banks and money market mutual funds don’t deserve a break after all this time.
Mr. Bernanke’s taper talk makes it clear that QE will begin to phase down and then end before short-term interest rates are allowed to rise. Since QE is really about longer term interest rates these days, I suppose that is good. Maybe when banks get a steeper yield curve, they will find better uses for their excess reserves and earn more than a quarter percent on them.
I know for a fact that Mr. Bernanke is smarter than I am—I used to sit next to him around the board table—but if I had a chance I’d ask him to explain to me why the reverse wouldn’t be better. Why wouldn’t it be better for the Fed to keep its good eye on the money supply to keep it growing, but let short-term interest rates as well as long-term rates seek more normal levels. Don’t slam on the breaks, but ease off the accelerator a bit.
One footnote: I don’t know how they came up with $85 billion per month for their security purchases. They were probably playing around with a 40 number and a 45 number and just added them together. But the number sounds awfully large and arbitrary to me. My hunch is that it was plucked out of the air. How ironic, then it must seem to Mr. Bernanke that a number plucked out of the air has become so sacrosanct. When he hinted that the 85 might be reduced to 70 or 75, the markets went berserk. I’m sure he will enjoy giving up some of that power, if that’s what it is. He deserves a good rest.