In the Financial Times today, Martin Wolf comes out swinging (free registration required) against those who are afraid the Fed’s Quantitative Easing programs carry a danger of sparking serious inflation.
The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending. Why is such privatisation of a public function right and proper, but action by the central bank, to meet pressing public need, a road to catastrophe? When banks will not lend and the broad money supply is barely growing, that is just what it should be doing (see chart).
The hysterics then add that it is impossible to shrink the Fed’s balance sheet fast enough to prevent excessive monetary expansion. That is also nonsense. If the economy took off, nothing would be easier. Indeed, the Fed explained precisely what it would do in its monetary report to Congress last July. If the worst came to the worst, it could just raise reserve requirements. Since many of its critics believe in 100 per cent reserve banking, why should they object to a move in that direction?
Now turn to the argument that the Fed is deliberately weakening the dollar. Any moderately aware person knows that the Fed’s mandate does not include the external value of the dollar. Those governments that have piled up an extra $6,800bn in foreign reserves since January 2000, much of it in dollars, are consenting adults. Not only did no one ask China, the foremost example, to add the huge sum of $2,400bn to its reserves, but many strongly asked it not to do so.
Everything he says is correct, but that’s not really any help, because the implications are pretty severe, even if he’s completely right.
First, let’s assume the Fed can, via repos or changes in reserve requirements, sterilize the increase in the money supply. The problem then becomes when does the Fed do this sterilization. let’s go back to 1981-1982. When the Fed was looking at monetary aggregates in the wake of the 1981 recession, they saw the money supply growing far faster than their target. At the time, the Fed’s primary tool was securities sales and purchases to control the rate of growth in the money supply directly, while letting the markets set interest rates. (Today, the fed primarily uses changes in the Discount Rate and Federal Funds target rate to run monetary policy.)
When the Fed saw those big increases in money supply, they immediately moved to sterilize the increases, to keep inflation in check. Sadly, the lack of velocity in the money supply, i.e., its actual rate of use in transactions, was near zero. as a result, the Fed’s tightening threw the economy into another recession, with unemployment rising to 11%. The policy may have been correct, but the timing was wrong.
So, what guarantee do we have that the Fed will perform sterilization at precisely the right time? If they move too early, the economy shuts down, a la 1982. Too late, and inflation takes off. Then the Fed would really have to tighten, which would probably result in another recession to wring out the extra inflation.
The trouble with the Fed is that monetary policy moves take 6-18 months to fully percolate through the economy. And they make these decisions based on economic data gathered in previous months. It’s like driving down the street by looking only at the rear-view mirror.
That makes proper timing by the Fed…hard.
Perhaps the Fed will operate as if run by infinitely wise solons, who know precisely when to sterilize their quantitative easing, either through repo operations, or raising the banks’ reserve requirements appropriately.
If it doesn’t, however, we’re looking at either another steep recession, or a bout of serious inflation, follwed by another serious recession to tame the inflation.
Oh, and even if the Fed is that good, it doesn’t address the problem of how the Chinese will react to any increased currency risk they face by holding dollar-denominated securities if the value of the dollar falls in the FOREX. As Mr. Wolf admits, the Fed’s mandate has nothing to do with the foreign exchange value of the dollar. So, maybe, the Chinese will decide to sell as much of their holdings in Treasuries as they can. That implies a serious decline in treasury prices, and a concommittant rise in bond yields, i.e., interest rates. Aaaand, we’re back to a possibility of a steep recession again Especially if they do it while the Fed is already in the middle of money supply sterilization operations.
So, I guess the question is, “How much to you trust in the ability of the Federal Reserve to do exactly the right thing, at exactly the right time?” And, “How much do you trust the Chinese to go along with all this?”
The Federal Reserve announced today that it would embark on a second round of “quantitative easing”, to the tune of $600 billion. This will join the previous round of $1.3 trillion over the last 18 months. For those of you who don’t know, Quantitative Easing is a monetary policy transaction, whereby the Federal Reserve buys securities from banks–usually US Treasury Notes and Bonds–with cash. This infuses fresh cash into the monetary system. After this second round of Quantitative Easing, the Fed will have injected $1.9 TRILLION in cash into the monetary system.
Now, sadly, the Fed did not, and does not, just have $1.9 trillion in cash lying around in big vaults to take Scrooge McDuck money swims in when the mood takes them. But that’s not particularly a problem, since the Federal Reserve simply prints up the required amount of cash (or creates it electronically for funds transfers). In any event, the Fed buys the securities with money that is newly made for that purpose.
With that in mind, my advice to you is to collect all of the printed currency you can. You will then need to package it in extremely tightly-wrapped bundles. Yes, it is a bit troublesome to do, but you’ll find that it burns much longer and hotter that way, which works far better for either cooking or heating purposes.
In fact, it may set in motion inflationary pressures that will blow up in the Fed’s face.
Randall Wray has put together one of the best summaries I’ve seen on the subject, and it doesn’t give me a warm fuzzy at all. Essentially QE2 (“quantitative easing”) has the Fed buying up toxic bank assets to push up their excess reserves. The thinking is that pushing those reserves into excess will stimulate loans. But it will also stimulate inflation.
Bernake’s claim is the reserve creation will be “temporary”. But – and this is the crux of the problem – it will have difficulty buying back those reserves because of the quality of the assets the Fed is sucking up to create them:
Bernanke carefully tries to navigate these waters by agreeing with the hawks that in the long run, Fed creation of too many reserves would be inflationary, but argues that in current circumstances the greater danger is deflation. Still, he reassures markets that reserves creation is temporary, and that the Fed will “exit its accommodative policies at the appropriate time”. Yet, if the Fed buys junk assets that will never have any value, it will not be able to sell these back to markets later — so there is no way to remove the reserves it created when it buys trash.
Indeed. So without the ability to sell back marketable assets, the reserves remain out there and inflation does too. You might think “deflation” is the biggest threat until you see run-away inflation reduce your retirement funds to zip and push your wages to poverty level.
This is a mess. And as we discussed in this week’s podcast, screwing with the economy at the central bank level is very delicate thing and could go wrong quickly and dramatically.
And what I’m hearing and reading – to include this article – says the possibility of that happening is high.
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