This week’s meeting of the Federal Reserve’s key policy making committee had all the suspense of a work by Gabriel Garcia Marquez or Eugene Ionesco in which you know a character is going to die, but first you have to wait out a long boring plot.
It seemed pretty clear before the meeting that there was a consensus within the Fed to increase the level of bank reserves in the economy and hence, at least potentially, the money supply by buying up U.S. Treasury bonds. Unknown were the size and duration of the effort. Those details are now cleared up: The Fed will buy more than $75 billion of bonds a month, for eight months.
What remains unknown are the effects, positive or negative, this will have on the U.S. and global economies. Those remain highly uncertain, with some prominent scholars taking sharply different points of view.
That division illustrates the degree to which, three years after the financial crisis began to unfold, we remain in uncharted waters. Mainstream economic theory focused little on the likelihood of such a crisis and even less on how to get out of one. So everyone now is improvising, even the Nobel laureates. Any forecasts are speculative at best. But there are a few things to understand.
First, buying or selling bonds is a normal activity for a central bank. Many news stories about the Fed describe its new policy as “highly unusual.” This reflects a lack of understanding of just what central banks like the Fed do year in and year out.
A central bank has no direct control, per se, over interest rates. What it does control is the level of reserves in the banking system. These are funds held by banks that are not lent or invested. The level of such reserves is closely related to the money supply. And it is the money supply that, along with demand for money by households and businesses, determines interest rates.
So whenever a central bank announces it is going to raise or lower interest rates, it means that it is going to change the money supply by changing bank reserves. To lower rates it increases the money supply. To raise them, the Fed reduces it.
To increase the money supply, the Fed buys bonds and pays for them by creating new money. In essence, it writes a check on itself. If some private individual or business that owns a bond sells it, a check is written that puts money into the account of the seller, but takes it out of the account of the buyer. When the Fed buys a bond, money similarly ends up in the account of the seller. But it doesn’t come out of the account of anyone else. It is new money created by the Fed to pay for the bond. And so the total levels of bank deposits, bank reserves and the money supply all rise as a result.
The Fed has done this for nearly 90 years. That is why it already owned some $800 billion worth of Treasury bonds before the current debacle began to unfold in 2007. That this buying and selling of bonds in open markets, along with insurance companies, pension plans and other institutions, is routine practice is precisely why the Fed’s policymaking body is called the “open-market committee.”
What is unusual, however, is that the Fed has continued to buy securities even after driving short-term interest rates to near zero. Also unusual: the scope of its purchases, adding twice as much to the Fed’s balance sheet in two years as in the previous 90. And the Fed’s purchase over the past two years of some $1.5 trillion of mortgage-backed bonds and other private securities is entirely unprecedented in all of central banking.
Second, while many news stories describe the Fed’s adopted policy as “risky,” there is risk in inaction, too. The economy is still dominated by great uncertainty, and whether the greater risk lies in action or inaction depends on one’s subjective estimate of the probability of different perils.
Increase the money supply too much, and you can touch off inflation. Moreover, increasing the money supply decreases the value of the dollar relative to other currencies. That is good for U.S. manufacturers and farmers who export or compete with imports. But it raises consumer prices. It also makes our country a less attractive place for foreigners to invest. It also can exacerbate trade tensions, although that may not be entirely bad right now. And if there are no attractive opportunities for businesses to invest in new plants and equipment, increased money can just slosh around the U.S. and world economy, causing new bubbles in stock prices and in foreign markets.
But if you don’t increase the money supply, an economy can slide into deflation as Japan did in the 1990s. That can inflict worse harm on an economy as consumption and investment slow and debts grow in size, adjusted for inflation. That is what advocates of the Fed’s actions fear most.
Third, the results of Tuesday’s election make clear that there is not going to be any more deliberate fiscal stimulus. So for Keynesians, monetary policy must do the heavy lifting. But even for those who reject Keynes, there is an argument that preventing deflation is a vital task.
The depth of disagreement is illustrated by the fact that one Nobel laureate, Paul Krugman, a Keynesian and Democrat, favors it, while Joe Stiglitz, also a Nobelist, Democrat and Keynesian, joins Martin Feldstein, a former Reagan adviser and advocate of limited government, in opposing it.
I personally think the Fed’s move is a mistake. But only history can render a verdict.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.