What Happens When the Fed Really Does Run Out of Ammunition?

The Fed has no good choices. If easy money ends, the economy will slow even more. But continuing the policy risks inflation

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Carolyn Kaster / AP

Federal Reserve Board Chairman Ben Bernanke testifies on Capitol Hill in Washington on Feb. 26, 2013

Stocks dropped sharply last week, with the Dow falling some 200 points, after the Federal Reserve released the minutes of its January Open Market Committee meeting. Although the minutes reaffirmed the Fed’s easy-money policy, they also showed that some members of the committee had voiced concerns. The dissenters cautioned that quantitative easing, the current program of massive bond buying, could not be continued indefinitely without serious risks.

Loading the Fed up with bonds creates the danger of big losses for the central bank if interest rates rise (which causes bond prices to fall). In a worst-case scenario, those losses could total half a trillion dollars over three years, according to one estimate. As a result, the January minutes included a carefully worded caveat: “Evaluation of the efficacy, costs and risks of asset purchases might well lead the committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.”

Fed Chairman Ben Bernanke remains undaunted, however. In his testimony before Congress on Tuesday he defended his easy-money policy, noting that it has “supported real growth in employment and kept inflation close to our target.” With consumer prices up only 1.6% over the past year, Bernanke declared: “My inflation record is the best of any Federal Reserve chairman in the postwar period — or at least one of the best.”

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In addition he argued that worries about potential losses on the Fed’s ballooning bond holdings were overstated. Careful portfolio management, he said, would allow the central bank to absorb the losses over time by trying to hold bonds to maturity rather than selling at a loss. “We could exit without ever selling,” Bernanke said.

This debate raises profound questions — probably not for the last time — about the effectiveness of the Fed’s easy-money policy. Why hasn’t it worked better? How long can it be continued? And, most important, what will happen when the Fed finally runs out of ammunition and quantitative easing comes to an end?

Bernanke’s decision to employ extremely stimulative measures was a response to the severity of the recession. One reason the downturn was so brutal was the bursting of the real estate bubble, which made many homeowners feel poorer and more cautious about spending. A second reason was that the financial crisis accompanying the recession eroded the capital of many banks and made them more hesitant to lend.

After recessions, the Fed normally lowers short-term interest rates to make it easier for companies to borrow and invest and for consumers to buy things on credit. But that remedy was insufficient to counter the most recent recession. So Bernanke cranked up the stimulus further and had the Fed buy bonds with money that the central bank essentially creates out of thin air. This bids up bond prices, which has the effect of reducing bond yields and other long-term interest rates. The process also increases the amount of money in the U.S. economy.

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Low interest rates and additional money can be stimulative — but only if people start spending and putting the money into circulation. And the massive scale on which the Fed is buying — $45 billion of bonds and $40 billion of mortgage-backed securities every month — has conspicuously failed to rev up the economy.

Bernanke has stated that the current round of quantitative easing that began in September will remain in effect as long as unemployment is above 6.5% and inflation is below 2.5%. That would be fine if the policy could be phased out as the economy picked up speed. But more than three years into the recovery, no speed is in sight. Indeed, GDP growth has slowed from a peak of 3.1% last year to virtually nothing. Recent tax increases — especially the payroll-tax increase — have created a drag on consumer spending. What’s more, any spending cuts or tax increases that take place in response to the approaching sequester could hobble the economy even further.

The upshot is that Bernanke appears to be painting himself — and the U.S. — into a corner. If the Fed stops its energetic stimulus, the economy is likely to get even worse. But continuing the stimulus ratchets up other risks.

For one thing, further stimulus will continue to increase the amount of money in the economy, which is not causing inflation at the moment but could become inflationary when the economy does accelerate. And as the Fed’s bond holdings keep growing, the portfolio becomes more and more vulnerable to a sudden rise in interest rates (despite Bernanke’s confidence that the Fed can manage any potential losses). As a result, some policymakers argue that while quantitative easing doesn’t need to end immediately, it shouldn’t be continued indefinitely.

(MORE: Is Asia Heading for a Debt Crisis?)

The ultimate problem, though, is that fiscal policy trumps monetary policy. There’s no way for the Fed to compensate fully, as long as Washington fails to address widely recognized budget problems, streamline regulation and reform the tax system.

Bringing the stimulus to a halt at a time when the economy is weak only increases the chance of a double-dip recession. But continuing with quantitative easing raises the likelihood of inflation at some point in the future and also increases the vulnerability of the banking system to a rise in interest rates. Trying to split the difference may avoid a double-dip recession, but only at the possible cost of stagnation and some inflation — or as it was called 40 years ago, stagflation.

27 comments
AlWinquist
AlWinquist

Bernake will be one of those fed idiots who destroys america along with obman - biden- pelosi-feinstein - reid-holder & co. And whos goin to suffer all americans who arent included in Obmans master plan!!

bilaljafar2010
bilaljafar2010

How we can Can Expect Spending will increase in future , if Income is decreasing

But Who cares, Certainly FED Don't because they will come again for their so called "rescue " because according to Ben bernanke

"QE HELPS AVERAGE AMERICAN, NOT WALL STREET" 

http://wallstnews.blogspot.com


RebelYell
RebelYell

Memo to author -- the Fed ran out of ammo long ago.  Monetary stimulus has never worked throughout its sorry history across the globe from the beginning of central banks.  It only serves to inflate asset bubbles.  The ONLY stimulus that has ever worked is permanent tax cuts -- in the US this was achieved in the 1920s, 1960s, and 1980s. 

"Gentle" Ben knows better, but he doesn't know what else to do.  His actions are a desperate attempt for the Fed to remain relevant.  In fact, it lost relevance long ago.

Prepare for $10,000 gold because the bond vigilantes will soon be on the prowl. 


billconner
billconner

The feds has this country by the short hairs and its because the miss management of Government the Government are like trained seals waiting for the fish as a treat and they will sell the american people down the road for there next fix

JohnBrown
JohnBrown

After 4 years of Obama engaging in more wasted corrupt spending than anyone in history, and running up more nation destroying DEBT than in the history of the world, and Bernanke printing more trillions of dollars to prop up Obama's DEBT they've given us the worst UNEMPLOYMENT for the longest period of time since the Great Depression, the worst recovery since the Great Depression, and the slowest growth during any 4 year Presidential term in over 60 years.  Governments borrowing beyond their means, and worse printing funny money by the bucket load has never turned out well.  Obama and Bernanke have used borrowoing and the printing presses to avoid the hard decisions they are paid to make, and do nothing but damage our economy at the core to accomplish nothing but create a fake bubble to help Obama get relected.  And the bubble will burst and things will then be 10X worse than they needed to be.   Obama has inflicted more DEBT and DAMAGE on the U.S. economy than any President in history, and Bernanke has facilitated it and is equally guilty!

antonmarq
antonmarq

There's really only one idea that will bring the U.S. and the global economy back into real shape, GET RID OF COMPOUND INTEREST. This idea has destroyed the world's global economies; moreover, it's based on a very faulty idea that money that remains unpaid can has the inherent opportunity to be lent to others; problem if what if others don't borrow it, then no interest is generated. And this is only one problem with the compounding idea. There are quite a few others no one wants to mention. 

AlecSevins
AlecSevins

I hope I live to see the day when all this superficial analysis ends, and leaders admit that a finite planet can't support endless economic growth, along with the unnatural population growth driving it.

There is plenty of evidence that the geological depletion of petroleum, also known as "Peak Oil," is at the root of this recession, and models based on perpetual growth via cheap energy need to be tossed out.

MarkRcca
MarkRcca

We rely too much on the consumer market to generate jobs.  Here are other things we should be considering.

1) Make the work hours more flexible; there are many people who would prefer to work fewer hours than the traditional 40 (mothers, students, semi-retired), but there are few part-time options for professional work (besides low-level service work).  Since employers find it easier to employ fewer people at more hours, offer tax incentives for employers, to create more jobs with a variety of schedules, and not just jobs with high hours.  

2) invest heavily in education, especially in fields where we have a shortage of labor.  Make education more accessible and therefore transition into high-demand fields easier.

3) Invest into infrastructure and R&D (that's already being done, but perhaps should do more)

BobJan
BobJan

run out of ideas, have a seance.

FamSvider
FamSvider

One point is missing.Fed lost control of money supply.If Fed decide to decrease liquidity and long term interest higher than today ,value of longer term notes and bonds they hold now will depreciate significantly .So if normally selling  1T will remove 1T from circulation ,but in this situation selling 1T possible will remove 500B only and only way to remove 500B will be to sell federal government real estate,if they will find buyers

llc.comco
llc.comco

They are not actually printing any paper money it's all electronic and bogus. I haven't seen any new money in a very long time. The money from banks is always old, wrinkled, torn, doodled and embarrassing.

IanShilling
IanShilling

The Federal Reserves losses will be $3.5tn, maybe $5.5tn, probably more. 

These losses will be attempted to be handed back to the taxpayer. 

The Fed is behaving like an absolute lunatic and there is no way out for the Fed. Huge losses are guaranteed. 

Not only is the Fed behaving like a lunatic they are actually making things MUCH WORSE.

http://ian56.blogspot.co.uk/2013/01/the-2tn-of-excess-bank-reserves-is.html


The frightening path the Federal Reserve and the government has set out upon.

http://ian56.blogspot.co.uk/2013/02/there-is-no-way-out-for-federal-reserve.html


Federal Reserve and government policy is EXACTLY the OPPOSITE of what should be being done. 

http://ian56.blogspot.co.uk/2013/02/the-us-government-and-federal-reserve_22.html 


JohnDavidDeatherage
JohnDavidDeatherage

Since 1977, the Fed has had a dual mandate; (1) price stability & (2) create full employment.  By trying fulfill the "full employment" mandate, the Fed overstimulates the economy resulting in recessions and crashes.  I suggest we limit the Fed to price stability, i.e. control inflation.  Employment is a by-product of the economic activity. Pursuing full employment leads to bad policy decisions.

When the economy recovers, the Fed's loose money policies will create inflation. Not if but when....

jwarrencollins
jwarrencollins

The future is known to all who are thinking and observing with open eyes and minds. The fiduciary responsibilities of national political leaders to the American citizenry has been completely abandoned. Energy resources follow money, not need. The years we had to lower debt are almost gone, and when interest rates rise, and they assuredly will, the service costs will overwhelm the ability to borrow. The act of science denial and resultant dearth of research investment will be expensive. Population levels are finite, defined by earth's ability to support it. It is meaningless to suggest that one person, elected or otherwise, can resolve the issue of collective ignorance, and reasonable now to assume that, as is historically demonstrable, only catastrophe will awaken the surviving class.

meddevguy
meddevguy

"After recessions, the Fed normally lowers short-term interest rates to make it easier for companies to borrow and invest", "But that remedy was insufficient to counter the most recent recession". Yeah, if your business gets every indication that the Administration is working overtime to raise taxes on you and your business and is making every effort to regulatory punish you, you would keep your money in the bank until somebody who understands that your business creates jobs gets into office.

My countrymen had a clear choice to select a candidate who could fix the recession by helping business create all of those tax-paying jobs and chose a charismatic leader with counter intentions. We all knew the outcome, now respect the power of the ballot box and live with it. Hey, a month ago we got our "taxes on the rich" enacted -- not sure my country is any better -- surprise.


rickcain2320
rickcain2320

@JohnBrown  

Actually it was Bush that doubled the national debt, not Obama, but Obama certainly is continuing the failed policy in Bush's name.

AlecSevins
AlecSevins

@MarkRcca You might want to investigate the whole folly of economic growthism. Man is living as if the laws of carrying capacity only apply to other species, which we're killing off in droves to suit our deranged form of progress.

"Consumerism" is a polite way to describe what's really going on. No other species constantly destroys (finite) nature and calls it "growth" just because credit debt can mask the physical depletion temporarily. A number of far-thinking people have written and spoken at length about needing restraint vs. mindless growth, but the message isn't reaching major leaders. Or, if it is, the leaders are afraid to talk about it because most people can't handle it yet.

MarkRcca
MarkRcca

@ViableOp Population isn't growing rapidly; there isn't need for many new houses, right?  

DeweySayenoff
DeweySayenoff

@famulla5 It would have been nice if you had used paragraphs in your wall of text.  It makes reading what you said much easier.  Perhaps something for future consideration.

DeweySayenoff
DeweySayenoff

@IanShillingInasmuch as I'm sure you have a point, posting multiple links to your own blog isn't what one would call compelling evidence for your argument.  No one wants to read that much from one person.  

Nothing you posted here contains any relevant information, merely accusation and innuendo. Links aren't going to be followed because of over-hyped Fox-News-style headline-like claims.  And to avoid getting flagged as a spammer, it's best to keep your links to a particular domain down to one.

As a fellow blogger, I recommend you actually make your points in summary, then post a single link to your site so those who are confused by your summary, or who want to verify your claims, can look up your proofs, which I assume are included as links in your blog.  They certainly aren't included here, which further undermines your post.

So provide more than hyped claims, make your case in summary and provide one link for those who might want to read further.  Stop being lazy in your posts.

DeweySayenoff
DeweySayenoff

@meddevguy Your post makes little sense, so lets look at reality: The economy still sucks. 

Businesses holding onto money just repays that to investors in a kind of fiscal circle jerk.  That money is kept out of circulation in an economic structure that demands money circulate in order to run properly.  Holding onto vast amounts of wealthy is a sure way to see the economy tank.  It's certainly not used to create jobs, but from a business point of view, it makes no sense to create jobs when there is no demand for the goods or services the business offers.

Stalemate - which is the situation we have in the economy.

The only way to stimulate the economy is to get the money flowing.  It went from the bottom up for 30 years, draining over 40 trillion (that's trillion with a T) dollars from those who tend to spend the bulk of their income - thus driving the economy - to those who do NOT spend the bulk of their income.  This, too, took that money out of economic circulation and into that business/investor circle jerk I mentioned.  (Fact check: in 1980, the wealthiest 20% of Americans, who mostly invest and don't spend the same proportion of their income as the other 80% do, controlled about 65% of the wealth of the United States.  Today, they control more than 93%, and it may be 94%.  The total wealth of the U.S. was about 154 trillion dollars.  28% of that is about 40 trillion dollars in today's money.  This is all a matter of public record.)

Every economist worth the title knows that new long-term job creation only - ONLY - comes from demand for the goods and services businesses offer.  Bottom-up spending is the only way to start or sustain it.  The supply-side economic (voo-doo economics) model has demonstrably failed since the wealthy have more money now than any time in the history of the country, and we have comparatively few sustainable living wage jobs opening up on the rare occasions when new jobs are offered.  People must first want to buy whatever it is that the businesses are selling.  And in order to do that, they have to have the money to spend for it in the first place.

That 40 trillion dollars would go a very long way toward stimulating the economy.

So while your argument is based more in political ideology than hard, economic fact, the fact is without increased consumer spending, the economy will never recover.  No business is going to hire ANYONE without an increase in demand for their goods.  And while the consumers who actually DO spend their income don't have the level of money or jobs to generate enough income for a higher amount of discretionary consumer spending, and while businesses and the wealthy who invest in them play footsie with each other using those trillions of dollars that used to circulate in the economy, the economy will remain stagnant.

Your ideological logic fails in the face of hard, economic law.  Businesses are feeding the investors who are feeding the businesses, wringing the last drops of fiscal blood from those who have the desire but not the means to spend enough money in enough places to have a chance of stimulating the economy.  Economic law demands only one solution to fix the economy, but political ideology stands in the way of that: Wealth redistribution.  Tax the wealthy - heavily - and reduce taxes on the rest.  Cut programs that only put taxpayer money into the pockets of businesses to reduce the deficit.  If it puts more money into the pockets of consumers, keep that in place.  CONSUMER SPENDING is the only cure for the economy we have today.

And while the wealthy may not be happy about it, they'll reap more rewards in a healthy economy.

Dachman
Dachman

Were you a crossing guard and hall monitor in school?

IanShilling
IanShilling

@DeweySayenoff We seem to agree entirely on the only thing that will fix the economy. Increasing the disposable incomes of ordinary people for bottom up spending. 

The government and the Federal Reserve are adopting EXACTLY the OPPOSITE of the policies required. 

They are lowering disposable incomes of ordinary people. 

The government by imposing a massive $200bn tax hike on the middle class in the Fiscal Cliff deal. 

The Federal Reserve by pumping up food & gas prices via massive printing and the speculative big banks which already have $2tn of excess reserves. 


Meanwhile Corporate Profits are at record levels and the government continues to hand out well over $1tn a year of Corporate Welfare and other government waste. 

Government and Federal Reserve policies ensure a deep and prolonged recession starting in 2013 and an increase in unemployment.  


Examples of Corporate Welfare that can easily be cut.  

$105bn a year for 7,000 mercenaries still in Iraq.
$170bn on building new and supplying existing foreign military bases.
$88bn per year on the Afghan war. Get out now.
$100bn+ of Medicare fraud.
Reduce the price of prescription drugs. America pays by far the highest prices in the world.
Stop the $200bn of new Corporate Pork a year.
Stop the futile war on drugs and save $200bn a year.
Fine the big banks $200bn+ for the harm they have done - it is easy to do.

Reform Corporation Tax. Ending the tax avoidance by offshoring US generated profits and other tax breaks given to multinationals, banks and arms companies would bring in $200bn a year.

End the personal tax avoidance schemes like carried interest and hedge fund managers diverting their remuneration through reinsurance schemes would also bring in more revenues.

Make the taxation system FAIR. Don't favor the rich and large multinationals over the little guy and small businesses.

There are many other ways of saving money and making the marketplace fairer.
The above adds up to $1,300bn a year. 
A lot more than that is possible. 

Details are on my blogposts.


tom.litton
tom.litton

@DeweySayenoff @meddevguy One note:  According to one of Paul Krugman's blog posts (can't find the link now, but i'm sure you can google for it), even the rich spend all that they earn, eventually.  It's just delayed.