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Why the Fed's action last week isn't as radical as you might think

By Neil Irwin

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.

By Neil Irwin  | November 10, 2010; 12:00 PM ET
Categories:  Federal Reserve  
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Next: Bank of America, J.P. Morgan home loan officials to testify before Congress

Comments

Radical is correct. If someone owed you $500 and they tried to pay you with 25 Xeroxed copies of a single $20 bill would you be satisfied? That's what the Federal Reserve did when they "purchased" that 600 billion in US debt. Since China owns the majority of our debt you can see why they weren't amused.

If China announces at the G20 summit they aren't purchasing any more US debt it's an instant game over for the US economy. Bernanke basically put the US economy on a Hail Mary play and if we are lucky we will survive. If Bernanke guessed wrong we go down taking the global economy with us. I'd say that stunt was a little radical.

Posted by: Desertdiva1 | November 10, 2010 1:19 PM | Report abuse

The fact is that there has never been a consensus on the value of Federal Reserve monetary policy even among Nobel Prize winning economists. Milton Friedman's arguments against it are well known. Many current leading economists do not favor the Federal Reserve's current policy. Any economist who claims that monetary policy has produced desirable results for employment over the last decade is simply professionally incompetent.

Posted by: dnjake | November 10, 2010 1:59 PM | Report abuse

The Fed is attempting to stimulate the economy since our congress will not do it. If congress had passed a stimulus package of sufficient size and had they targeted it properly, there would be no need for the Fed to institute Quantitative Easing. The stimulus was much too small and too targeted to tax cuts. We desperately need infrastructure spending, not tax cuts. We are taxed less now than any time since 1950.

Posted by: chuckhuffstutler | November 10, 2010 2:20 PM | Report abuse

Quantitative Easing by injection of Money into our Nations Money Supply is harmful to the Economy. These are the very things that cause the Damaging Boom that precedes the Bust in the Economy. This is apparent from the QE of Alan Greenspan after the Dot Com Bust then the next Boom in Real Estate that has led in part with other factors to the present Recession. We all see this from the recent past. This has taken place many times since the Chartering of the Federal Reserve. The very "Stabilization of Prices and Full Employment" the mission statement of the Fed as it were has been a failure from it's inception. 20th Century inflation and prolonged Boom Bust cycles can be placed at the feet of the Fed. Republican Presidential Primary Candidate Representative Ron Paul from Texas being Libertarian on Economic Issues has Assailed the Federal Reserve on this issue and has has argued about this for years. He has espoused this in his book "End the Fed". Not withstanding that there should be a Federal Reserve in the first place take a look at

Professor Mark Thornton's article at the Mises Institute

Bernanke's Solutions Are the Problem

http://mises.org/daily/4798

Reading thru the link above note Professor Murray Rothbard's America's Great Depression at the end.

This book from Rothbard gives an exhaustive account of the The Causes of the Great Depression. The formation of the Federal Reserve and it's contribution to the Boom and Bust Cycle. Also it talks about the Bust of 1921 which was a crash greater than the initial crash of 1929. President Harding did basically nothing and the economy recovered on it's own very quickly. After Harding President Coolidge ignored Herbert Hoovers unsolicited advice to intervene in the Economy. Prof. Rothbard uses his expertise in the "Austrian School of Economics" to explain why there was a Boom then Bust. Reading AGD a few years ago I got a Chill of "Deja Vu" noting the Dot Com Boom/Bust of 2001 was just like the Damaging Boom of the 1920's. Looking at how the Fed and Treasury Dept. are repeating the 1920's Playbook yet again that Chill has turned to a freeze.

A free pdf. from the Mises Institute is available here among purchase choices you can make.

http://mises.org/resources/694

Posted by: 625shapiro | November 10, 2010 3:56 PM | Report abuse

Everyone is missing the real problem.

There are $4 trillion in USD Treasury securities sitting in 10 central banks...China alone could undo the FED's action by following India's move by dumping Treasuries for gold or follow the Gulf States to gold/oil or follow World Bank's rec. for a group of currencies (new SDR).....

We have destroyed our international standing...and the impact of that will subvert the stated FED goals....interest rates will rise, oil will go to $200, inflation will increase, trade deficits will increase and the stock market will decline...and the FED's reversal of QE will not put the genie back in the bottle...the USD will never be the reserve currency ever again.

Posted by: Anonymous | November 10, 2010 4:44 PM | Report abuse

This is all Obama's fault!...Thank you Sarah for pointin out the sophisticatin stuff about this stuff.

Posted by: Anonymous | November 10, 2010 5:33 PM | Report abuse

Be sure to always order two beers at the start because the price is certain to go up while you are sitting at the bar.

Posted by: droberts57 | November 10, 2010 8:08 PM | Report abuse

Quantitative easing is the equivalent of an endless colonoscopy without a sedative and pain reliever.

Is it radical? Yes, it is radical insanity. Inflation is going through the roof and the dollar is sinking like the Titanic.

Posted by: alance | November 11, 2010 2:28 AM | Report abuse

I agree with Anonymous. As the Dollar declines from the massive foreign debt, the tendencies of major institutional and sovreign money holders (dollars and US Treasuries) may end up taking a flight to Commodities (Gold, Oil, Agricultural Futures).

In my previous comment on this thread I gave our Central Bank the Federal Reserve a thrashing. This has happened before in our economy. During the Inflation run up thru the 1960's France and Germany were alarmed at the weakening dollar. The Federal Reserve creates money out of nothing, I go buy French Wine and German Volkswagons. I hand over these dollars. After a time as all these Fed Reserve Dollars work their way thru the world economy the inflation they create lowers their value. Before the French and German sellers can enjoy the fruits of their labor they have lost to inflation. In effect I as an American have bought real consumer products (wine,volkswagon) with Monopoly Game money.

Under the Post World War II Breton Woods Monatary agreement the strong US Dollar became the World Exchange currency Pyramided on Gold. Sovereign Country's Central Banks could exchange Gold to take care of Imbalances. At the first sign of French-German demands for Gold, the US muscled Germany with the NATO card, Germany fearful of the Communist Block knuckles under. France's response is to quit NATO. Round Two France demands Gold for it's dollars. President Nixon closes the Gold Window of Breton Woods Agreement to Exchange for Dollars. France's response is to let the dollar float against the Franc. Since then there have been these so called Clean and Dirty Floats. Without Sovereign Gold exchange the Federal Reserve has seen fit inject dollars massively into our Banking System.

In the 1970's I lived thru and observed Stagflation (Stagnant Economy plus Inflation), Oil Shocks, High interest rates and Federal Reserve Chairman Volker putting the brakes on the Dollar. I won't be taken in the in the future by the Accolades thrown on any Federal Reserve Chairman (1990's Alan Greenspan- Maestro) during a Fed Induced Economic Boom. A Boom Greenspan ascribed that "Today we are in a New Economic Era of Low inflation and Economic Prosperity"
Unfortunately he was just having his day in the Sun During the Boom, then came the Bust.

Some Resources

In this 1969 Essay before the Gold Window was closed by Nixon and Super Stagflation started Economist Murray Rothbard put forth this Essay:

Economic Depressions: Their Cause and Cure
Mises Daily: Thursday, October 02, 2008 by Murray N. Rothbard. A Mini Book issued originally in 1969

http://mises.org/daily/3127

A More Modern Treatment by Professor George Reisman lays out a Austrian School of Economics path taught earlier by Professors' Ludwing von Mises and Murray Rothbard. basically Private Banking and 100% Gold Backed Currency with no Fractional Reserve Banking

A Pro-Free-Market Program for Economic Recovery

http://mises.org/daily/3870


Posted by: 625shapiro | November 11, 2010 12:13 PM | Report abuse

I must round out my comment thread above as I've exceeded the 3,000 character limit

Professor Rothbards' monograph "The Case Against the Fed"

http://mises.org/resources/3430/The-Case-Against-the-Fed

And properly attribute Professor Reisman below

Professor Reisman is a contemporay of Rothbard.
Reisman is acknowledged by Rothbard in the Preface of the later's Economics Book "Man, Economy and State" for assisting in solving and clarifying some issues in the book.

Reisman's "A Pro-Free-Market Program for Economic Recovery" is fairly current exposition considering Professor Rothbard passed away in 1995. And for some Icing on the Cake Reisman's speech was given in Nov 2009 Just two months after so called end of the Recession

The The National Bureau of Economic Research, a panel of academic economists based in Cambridge, Mass., said the recession lasted 18 months. It started in December 2007 and ended in June 2009

Of course this was announced Late September 2010 Ten Months Later.

Whom do we believe anymore, I side with the Dr. Ron Paul and the Austrian School of Economics.

Posted by: 625shapiro | November 11, 2010 4:06 PM | Report abuse

America… We The People
America’s addiction to buying cheaper imported goods is a national crisis
Interests opposed to strengthening the US economy extend beyond sovereign nations. 55% of China’s export is contributed by foreign owned companies. These beneficiaries include US firms. These firms are aggressively lobbying to keep the steady flow of profits derived from foreign produced goods flowing in to the US.

The most effective weapon used against the US is the inject of fear. At every opportunity, we should replace the words Protectionism” and “Retaliation “with the words of Franklin D. Roosevelt, “There is nothing to fear but fear itself”.

Yao Yang, an expert on China policy pointed out in an article in the Financial Times, “China will only undertake a fast revaluation if other countries can credibly threaten punishment. The long-standing view in China is that the US and its allies lack the will to punish, even if they may have the means. Germany, may also not want to go too far in criticizing China, because those criticisms can easily be used by the deficit countries against themselves”. In this high stakes poker game the US is a net importer , so it wouldn’t fare near as bad as China or Germany going “ALL IN “ against their bluff of an all-out trade or currency war.

We can do our part by publically identifying the US companies whose shares of profit are disproportionately derived from importation into US consumer markets.

Armed with real information we can unite in a collective voice and use our pocketbooks to reward US companies that defend our way of life and punish those that don’t. Protecting our domestic industries in not a throwback endorsement of the failed policies of labor or the stranglehold they had on corporate America.

It is a path to prosperity born out of the same productivity increases that came from entrepreneurship, the revitalization of small business and real value added innovation. But just as we did in WWII we need to build the US capital base and stop shipping all our treasure overseas in exchange for trinkets.

Readers of this forum don’t play at the checkers level, because you are masters at chess. PLEASE do your part to save this democratic nation. You can start right NOW by naming the names of the companies that you think deserve a seat at the top for defending our way of life and naming names of those who deserve to feel the heat.
GOD BLESS THIS NATION AS WE STAND UNITED TO SAVE OUR WAY OF LIFE.

Posted by: radioceleb99 | November 11, 2010 5:12 PM | Report abuse

America… We The People
America’s addiction to buying cheaper imported goods is a national crisis
Interests opposed to strengthening the US economy extend beyond sovereign nations. 55% of China’s export is contributed by foreign owned companies. These beneficiaries include US firms. These firms are aggressively lobbying to keep the steady flow of profits derived from foreign produced goods flowing in to the US.

The most effective weapon used against the US is the inject of fear. At every opportunity, we should replace the words Protectionism” and “Retaliation “with the words of Franklin D. Roosevelt, “There is nothing to fear but fear itself”.

Yao Yang, an expert on China policy pointed out in an article in the Financial Times, “China will only undertake a fast revaluation if other countries can credibly threaten punishment. The long-standing view in China is that the US and its allies lack the will to punish, even if they may have the means. Germany, may also not want to go too far in criticizing China, because those criticisms can easily be used by the deficit countries against themselves”. In this high stakes poker game the US is a net importer , so it wouldn’t fare near as bad as China or Germany going “ALL IN “ against their bluff of an all-out trade or currency war.

We can do our part by publically identifying the US companies whose shares of profit are disproportionately derived from importation into US consumer markets.

Armed with real information we can unite in a collective voice and use our pocketbooks to reward US companies that defend our way of life and punish those that don’t. Protecting our domestic industries in not a throwback endorsement of the failed policies of labor or the stranglehold they had on corporate America.

It is a path to prosperity born out of the same productivity increases that came from entrepreneurship, the revitalization of small business and real value added innovation. But just as we did in WWII we need to build the US capital base and stop shipping all our treasure overseas in exchange for trinkets.

Readers of this forum don’t play at the checkers level, because you are masters at chess. PLEASE do your part to save this democratic nation. You can start right NOW by naming the names of the companies that you think deserve a seat at the top for defending our way of life and naming names of those who deserve to feel the heat.
GOD BLESS THIS NATION AS WE STAND UNITED TO SAVE OUR WAY OF LIFE.

Posted by: radioceleb99 | November 11, 2010 5:13 PM | Report abuse

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