Why the Fed's action last week isn't as radical as you might think
There's no doubt that the Federal Reserve's move to boost the economy last week was dramatic and carries risks. But much of the chatter around the move, including at the G-20 gathering of top world leaders in South Korea, is making it out to be far more revolutionary and unconventional than it really is.
In fact, while there is plenty of room to debate the wisdom of the Fed's action, it is consistent with the long-standing and widely accepted principles of monetary policy. Or it's at least as consistent as possible, given that the Fed's short -term interest rate target is already at zero.
Let's start from the fundamentals. The Fed's planned "quantitative easing," through which it will buy $600 billion in Treasury bonds over the next eight months, is designed to work by lowering long-term interest rates across the economy.
The Fed has a dual mandate from Congress: It is to aim for maximum employment and stable prices. Fed officials view maximum employment to be about a five percent jobless rate and stable prices to mean about two percent annual inflation. Now, the unemployment rate is 9.6 percent, and inflation is running around one percent. In normal times, the Fed would respond to high unemployment and low inflation almost mechanically by cutting its short-term interest rate target, but it can't do that because the rate is already near zero.
So, the Fed needs to ease monetary policy but can't use its normal tool to do so. It's turning to a strategy that is different but affects the economy the exact same way: It's buying a set amount of bonds rather than targeting a short-term rate. Both tactics are aimed at helping the economy by lowering interest rates, which gives consumers and businesses greater incentive to spend and invest.
The $600 billion in Treasury bond purchases are, in the Fed's internal estimates, about the equivalent of cutting the Fed's normal interest rate target by three-quarters of a percentage point. (Although because there is less experience with quantitative easing than there is with adjusting the federal funds rate, that estimation is still uncertain. It may be better to think of it as similar to a rate cut of between a half and a full percentage point.) That's a significant rate cut but hardly unprecedented. Indeed, my guess is that if it weren't for today's zero lower bound on interest rate, the Fed would have already cut short-term rates by one to two percentage points over the last few months.
Talking about buying $600 billion in bonds by printing money sounds a lot scarier than saying "cutting the rate target by three-quarters of a percentage point." But the two are basically identical in terms of how they flow through the economy more broadly. Both strategies create greater incentive for consumers and businesses to spend money now rather than in the future. They push up asset prices and push down the dollar, making exporters more competitive.
The move is risky. The dollar could weaken too much, helping the nation's exports but making it more expensive for U.S. consumers to buy goods from overseas. The changes could trigger a stock market bubble. But the most commonly mentioned concern is inflation: If the economy starts to heat up, banks sitting on this extra $600 billion in reserves will start loaning it out. The money supply could increase very rapidly, and prices would rise. Fed officials say that if this happens, they would reverse course quickly and tighten the money supply. As Fed Chairman Ben S. Bernanke said during a panel discussion Saturday, the central bank has not increased its target for inflation -- it still views two percent as the optimal rate for price increases.
There's plenty for debate on the relative costs and benefits of the Fed's action. It's a question that played out at the Fed policy meeting last week and is circulating among analysts and economists around the globe. But whatever one's views of whether it was the right move -- very smart economists differ over monetary policy all the time -- this just isn't as radical as much of the recent commentary is portraying it.
What would be a truly radical approach by the Fed? More on that in my next post.
| November 10, 2010; 12:00 PM ET
Categories: Federal Reserve
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