Save the economy, free the Fed

by pdxblake

The idea of quantitative easing (QE) is poorly described in the best of times and its effects even worse explained.  When Rick Perry threatened Ben Bernanke with being treated “pretty ugly” in Texas, he was basing his comments in part on the common misunderstanding that QE is printing money, which he believes will turn America to Weimar Germany or Zimbabwe, countries where inflation has turned into hyperinflation.  On a strictly literal point, the whole idea of QE as ‘printing money’ is totally wrong and confuses how the Federal Reserve’s balance sheet works (QE increases its assets by buying bonds, funded by issuing money, which are liabilities of the Fed).  This point is immaterial, but it bugs me that even this point is wrong.

That point, and most about what the Fed does and how it operates are largely misunderstood by people, but the impacts of the Fed policies are important.  There was no need to explain it all when normal moves up and down in interest rates were sufficient to prod the economy up and down to smooth the economy (either by acting as a drag when growth was strong but inflation was rising, or as a push when inflation fell along with growth).  However, the bursting of a real estate and financial bubble that happened in 2007-2008 put a huge weight on the economy which is still struggling to grow, and traditional ways for the Fed to act are closed with interest rates at 0 (well, technically between 0 and 0.25%, which is the same in practice).   Interest rates could go negative, but it is not an area where central banks operate (Japan is an exception and has recently opened up the possibility of negative rates again; it’s been struggling after its dual financial-real estate bubble burst in the early 1990s).

Current Fed chair Ben Bernanke has a history of studying the Japan central bank , and so you’d expect he’d be well prepared to deal with an economic depression triggered by the same factors as the Japan’s (his analysis of Japan led him to get the nickname “helicopter Ben”). But, when it comes to how he has led the central bank, it has been much more timid than his predecessor Alan Greenspan, who had a much more dictatorial approach that may have caused some of the Fed’s dithering between the rounds of QE (and that is the nicest thing I will ever say about Alan Greenspan).  Bernanke’s more consensus-based approach with much more clarity in his statements is good, and will be an important legacy of his time at the Fed, but is not great for the economy where it is with a Congress that is held captive by Republican ideologues who have the same prescriptions for economic policy as they always have (tax cuts for the rich, cutting regulation and shrinking the size of government as long as it doesn’t touch anything that will help them get re-elected).

That consensus-based approach, as well as the greater openness from the Fed does let them launch trial balloons, for instance, this past weekend, when John Williams, a voting member of the Fed Open Market Committee (FOMC) was interviewed by the FT, he

“forecast that unless “further action” was taken, there would be a lack of progress in boosting the jobs market – where the unemployment rate has been stuck around 8.2 per cent since the start of the year – over the next 18 months”.

“He added that there would also be benefits in having an open-ended programme of QE, where the ultimate amount of purchases was not fixed in advance like the $600bn “QE2” programme launched in November 2010 but rather adjusted according to economic conditions.”

Williams is viewed as near the center among the FOMC on moving forward on QE3 and so his words are similarly taken as guidance for future Fed action, just as Greenspan’s incoherent ramblings were while he was Fed chair.  Hopefully, the Fed will move forward on something as big and open-ended as Williams describes because what kept Japan in its no-growth mode for so many years was not that the policies it tried were failed policies.  It was, instead, that they were done in fits and starts.  The same can be said in the US for fiscal stimulus.  The $787 billion stimulus was done, and had a positive effect on the economy, but was not large enough to offset the scale of the depression we remain in.  QE1 and QE2 were also successful policies, but had fixed end dates that were not enough to offset the additional headwinds that came afterwards (like the European debt crisis, which is back with a vengeance).

The Fed coming out with a “do whatever it takes, as long as it takes” approach is overdue and will be decried by the party that has spent 2 years killing the economy to beat Obama in 2012.

UPDATE (7.23.12, 4:30pm): A chart from the Wall Street Journal (ht Menzie Chinn) shows excellently why the Fed’s own dual-mandate (maximum employment with price stability) is not being fulfilled, which should compel the Fed to act.

The 2% inflation target is well known and Bernanke has made it explicit, but I don’t know where the 6% level came from.  Presumably that is what the WSJ believes the NAIRU, or the non-accerating inflation rate of unemployment, is.  A Federal Reserve Bank of San Francisco paper co-authored by John Williams leans more toward a 5% NAIRU, while noting that the Congressional Budget Office estimates the NAIRU at 5.2%.