Late last week the Wall Street Journal reported that the Federal Reserve was considering a sophisticated new form of stimulus called sterilized bond buying. The market rallied, with many investors apparently hoping that the maneuver would energize an economy that remains sluggish more than two years into the recovery. Meanwhile, conservative commentators like Larry Kudlow denounced the strategy as “typical Fed tinkering,” and basically “a lot of hooey.”
I take a different view of Fed Chairman Ben Bernanke’s latest idea: I don’t think there’s anything wrong with sterilized bond buying as a concept. I just don’t believe there’s any way it can have a significant impact on the economy. Basically, it’s a desperate effort by a Fed that has used up almost all of its serious ammunition fighting off an economic slowdown and is now reduced to carrying on with only wooden swords and paper hats.
The crucial challenge that a central banker always faces coming out of a recession is how to rev up the economy without simultaneously revving up inflation. So far, Chairman Bernanke has only half-succeeded on either point. The recovery has been steady, but not robust enough to bring unemployment down below the 8% mark. Yet, inflation has crept up from 1.6% in 2010 to 3% last year, the level at which alarm bells start ringing, according to conventional wisdom.
Sterilized bond buying is a way the Fed hopes to give the economy a last extra nudge without pushing inflation higher than it already is. The plan is essentially to focus all remaining ammunition on what many economists feel are the most important targets: The still-moribund housing market and business investment, which has been disastrously weak in the current recovery. To do that, the Fed would purchase long-term bonds and mortgage-backed securities, thereby pushing down long-term interest rates, making it less costly for Americans to buy homes and for businesses to expand.
At the same time, though, the Fed would try to avoid adding to inflation by pulling a more or less equivalent amount of money out of the economy at the short-term end of the yield curve. Of course the Fed doesn’t want to drive up short-term interest rates in the process. So rather than actually withdrawing the money from the banking system, the idea is to “sterilize” it. In practice, that means the Fed would merely borrow it – taking it out of the system temporarily – with a promise of repayment.
This may all seem overly complicated. Or it may seem worthwhile, if you’re the sort of person who thinks it’s better to light a single candle than to curse the darkness. But while such adjustments probably will work in a technical sense, there are at least three reasons to think they can’t really have much impact on today’s important economic problems:
The Fed’s scheme isn’t really new – in fact, the Fed is already doing it. Sterilized bond buying is just a variation of something the Fed thought up in the 1960s, which came to be called the Twist after the popular dance of the time. (Critics who thought the scheme was largely bluster called it the Twist and Shout.) The Twist consisted of selling some of the Fed’s inventory of short-term debt (which slightly raised short-term yields) and using the money to buy long-term bonds (which slightly reduced long-term yields). Last September, in fact, the Fed began a $400 billion program that is a modern version of the Twist. Sterilized bond buying would just be a more sophisticated variation.
Even if sterilized bond buying works, long-term interest rates won’t be reduced much. Experts estimate that deft intervention in the bond market could lower bond yields by one-quarter of a percentage point. That would be important for bond traders who bet millions of dollars on tiny shift in yields. But it will make little difference to a corporation considering expansion or to a potential homebuyer. With inflation running about 3% over the past 12 months, a normal level for long-term Treasury bond yields would be a little bit above 4.5%. In fact, a year ago 20-year T-bond yields were 4.4%, close to that expected level. Since then, however, 20-year T-bond yields have fallen to 2.9%, largely because of the Fed’s easy-money policies. If that huge drop in long-term interest rates hasn’t been enough to produce a roaring economy, how much can another quarter point drop really matter?
Inflation will probably gather momentum for other reasons. Since 2009, the Fed has pumped hundreds of billions of dollars into the economy. That hasn’t produced serious inflation yet, because the economy is still somewhat weak. But if the recovery does gather momentum, consumers will start spending more, and the money already injected into the banking system will become more inflationary. At this point, the Fed should be thinking about when it will have to start draining money from the system, thereby raising interest rates a bit, not trying to find clever ways to add a little more money.
Tweaking interest rates is, of course, what central bankers do for a living. So a short-term program of sterilized bond buying may prove to be a triumph from their highly technical perspective. But interest rates are not what is holding back business investment right now. Experts may debate what the key issues really are, but the list would likely include regulation, taxes, trade policy and the availability of skilled workers. Similarly, pressures for greater inflation reflect levels of government spending, taxes and borrowing. All these things are questions for the President and Congress, not things the Federal Reserve can materially change with deft technical adjustments.