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.
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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.