Time for Congress to act
What will you do, what will you do? Whether this reminds you of Karl Malden’s ads for American Express Travelers Cheques or of Mike and the Mechanics, it is an apt question for Chairman Ben Bernanke and the policy-making arm of the Federal Reserve, the Federal Open Market Committee.
With the spate of less-than-encouraging economic data for the United States and other countries, the odds are increasing that there will be another round of Fed stimulus. The problem is that there shouldn’t be.
In lieu of a coherent fiscal policy, the Fed initiated its program of economic stimulus in late 2008. That first round of quantitative easing, dubbed QE I, occurred because the Fed had already pushed its key policy tool, the federal funds rate, essentially to zero. With that deterrent against recession spent, the Fed started purchasing non-government securities, many of them mortgage backed securities, to the tune of over $1.25 trillion.
Facing a still elevated unemployment rate in late 2010, the Fed launched QE II. The goal of this $600 billion buying spree of additional financial assets was to further reduce interest rates and encourage investment and boost the hesitant economic expansion.
Did QE work? Estimates by the Federal Reserve Bank of San Francisco suggest that, without the Fed’s intervention to lower interest rates economic, growth would have been slower and the unemployment rate would be higher than what they turned out to be.
But QE I and II didn’t succeed enough. About a year ago the Fed announced another stimulus program. In the modern version of operation twist, the Fed would exclusively purchase long-term Treasury securities to lower these interest rates relative to short-term rates. Today, rates on 10- and 30-year Treasury securities are at historic lows. As these rates fell, so too did mortgage rates.
With this track record, why not QE III?
Markets, whether for shoes or financial instruments, establish prices. Rising and falling prices reflect information about changes in demand for and supply. When the Fed bought securities in its QE programs, it distorted the informational content in interest rates on these assets. The fact that the rate on a 10-year Treasury security is negative after adjusting for (low) inflation suggests that something is amiss.
The Fed’s unprecedented purchase of financial assets has upset the distinction between safe and risky assets. Historically, one measure of risk was to compare the rate of return of an asset to a riskless rate, usually the three-month Treasury bill rate. With three-month Treasury bill rate effectively zero, the apparent riskiness of private-sector securities has risen. This artificial environment inhibits investors’ ability to assess relative risk, which raises uncertainty, reduces business investment and stunts economic growth. And the unemployment rate remains elevated.
What more could be expected from yet another round of quantitative easing? Repeated actions are subject to diminishing returns. With short-term interest rates already near zero and longer-term rates at historic lows, little would be gained by another 10 or 15 basis point drop in the 10- or 30-year rate. A mortgage rate of 3.25 percent is not likely to induce a flood of buyers that were unwilling to enter the housing market when the rate was 3.35 percent.
The Fed has done enough, perhaps even too much, in its quest to lower the unemployment rate. It is time for another policy lever to be pulled.
It is Congress, not the Fed, who must act. Politicians must look past the upcoming election and stave off the looming economic debacle by extending the existing tax program and rescinding the proposed cuts to spending. It is not the long-term solution to our economic and fiscal woes, but it would provide some breathing room for policy discussions to begin in earnest.
Taking such action quickly, before the election, would help reduce uncertainty and give the Fed’s previous policy actions a chance to gain traction. Unfortunately, getting re-elected will likely trump resolving the pending economic crisis.
R.W. Hafer is distinguished research professor of economics and finance at Southern Illinois University Edwardsville and a research fellow at the Show-Me Institute.