According to the Federal Reserve, it has two things to consider when formulating monetary policy:
Monetary policy has two basic goals: to promote “maximum” sustainable output and employment and to promote “stable” prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act.
Following a path of zero interest rates into quantitative easing (buying bonds at the long end of the yield curve) will impair its ability to achieve either of its stated goals. The following explanation is a bit wonky, but bear with me.
A Brief Overview of How the Fed Manipulates the Money Supply to Achieve its Goals
The Federal Reserve controls nothing except the supply, and therefore, the price of money. To decrease the price (interest rate) of money, it increases the supply of money by purchasing securities through its open market operations. To increase the price of money, it sells securities it holds, sopping up liquidity (supply) like a sponge. The Fed increases the supply and decreases the price of money if it seeks economic growth, and decreases the supply and increases the price of money if it seeks to control inflation (which is when the overall price level increases due to an excess supply of money). Traditionally, the Fed has attempted to increase and decrease the supply of money through purchases of short-term (less than thirty days) obligations, i.e., in the past, it has mainly focused its operations on the short end of the yield curve. The yield curve is simply a graphical depiction of the relationship between interest-rates and maturities. Generally speaking, the shorter term is the obligation, the lower will be its interest rate, all other things equal.
The Fed seems to believe (based on the pronouncements of its leaders, like Dudley, below) that this manipulation in the price and supply of money can cause real economic growth, i.e., growth not simply attributable to the inflationary aspect of providing more money to chase the same number of goods and services. This is arguably not true. There have been periods of economic growth that had no or declining inflation (the eighties and nineties), and there have been periods of high inflation with little or no real economic growth (the seventies). While correlation does not equal causation, a lack of correlation conclusively prohibits a conclusion of causation. “A” appearing with “B” means A may cause B, or vice versa. But “A” appearing without “B” means neither can cause the other. But nobody much believes that economics is a science, except perhaps Fed economists claiming to be able to engineer the outcomes of a $12 trillion economy by dint of manipulating the money supply.
The strategy of increasing the money supply and decreasing its price in order to achieve maximum sustainable output is now at its lower bound. The price of money (interest rates) can’t go nominally below zero. Nominal interest rates are the stated rates; real interest rates take account of inflation. Real rates can and often do go below zero, as they are now, with short-term obligations earning basically nothing, and inflation running at about 1% a year.
With unemployment still well above 9%, it is clear that the Fed is thus far failing to achieve “maximum sustainable output and employment”. But with short-term interest rates already at zero, what to do? The Fed now plans to focus its efforts on the long end of the yield curve by purchasing obligations with maturities of five years or more. This is called quantitative easing, but it is effectively no different than its open market operations on the short end of the yield curve. In either case, the Fed specifically attempts to diminish the value of money. In other words, in both cases the Fed seeks inflation. Though one half of the dual mandate is achieving “stable prices” the Fed takes “stable” to mean an inflation rate of between one and two percent per annum.
Will it Work?
In short, no. Neither of the Fed’s dual mandates will be achieved via a renewed push to flood the market with dollars in order to decrease their prices. It’s not clear how the Fed could believe that pursuing more of the same strategy would achieve different results, but as mentioned earlier, this economics stuff, particularly for central bankers, is far removed from the rational objectivity that is supposed to guide scientists.
Why QE Won’t Solve the Long-Term Unemployment Problem:
In the short run (less than two years), if the Fed can initiate a real inflationary spiral, it may relieve some unemployment, but it will do nothing to solve long-term structural issues facing the labor markets. A high-enough inflation could make hiring at the minimum wage desirable again, so long as the minimum is not indexed to keep up with inflation, and it could make salaries held constant due to business conditions less costly for employers. In other words, inflation could operate to put more people to work so long as wages don’t keep up, which is to say, if inflation induces a real decline in wage rates, then the unemployment rate should decrease, but only in the short run.
This is effectively the mechanism by which the Fed stoked employment during the late nineties and aughts, as wage rates should have been declining along with overall prices, due to the huge imbalances between wage rates and prices in the US and China, and other similarly less-developed and thereby less expensive, trading partners. That US wages and prices stayed mostly stable illustrates how heavily inflationary was Fed policy during the era.
In the long run, inflation distorts supply and demand metrics for all goods and services, including labor. Inflation initially makes it appear there has been an increase in demand (“Hey Joe, I got me a job making $10/hour”) when in fact all that has changed is the metric by which supply and demand are measured. The illusion prompts suppliers to expand production to meet the illusory demand increase. After a period of time, the illusion due to inflation wears away, and the quantity demanded returns to its natural level. The market is oversupplied for its natural level of demand, and prices decline, falling below what was the equilibrium price before the inflationary episode began. Labor, so far as its price has a lower bound in the minimum wage, sits idle again, at an even larger rate than before.
Why QE Won’t Achieve Stable Prices:
If the definition of “stable prices” is, as the Fed believes, inflation of one to two percent a year, quantitative easing will ultimately achieve exactly what the Fed is trying to avoid, i.e., deflation, in much the same mechanism for the broader economy as described just now for the labor market. It is the same as the effect tax credits for homeowners and the credits provided for car buyers that traded in old vehicles for new had on their respective markets, except operating on an economy-wide scale. If consumers believe there will be higher prices in the future, as the end of programs to pay purchasers of cars and vehicles was understood, tomorrow’s purchases will be pulled forward for today. In both instances, as soon as the higher prices (i.e., the end of the programs) took effect, the bottom fell out of the markets. Sales plunged, and prices would have too, except for the inherent stickiness in prices of assets purchased mainly with credit. When this sort of thing happens across an economy, where prices for everyday goods aren’t so sticky as those for cars and houses, the economy actually experiences an overall decline in prices, partly due to deflation, but mostly due to oversupplied demand caused by inflation.
But why would there be an end to the anticipation of higher prices? For two reasons: First, is the end of illusions about the true quantity of demand. Once the regime of higher prices is anticipated to continue indefinitely, the temporary illusion of higher demand due to higher prices will fade, and the realities of the market will clarify. There is no reason to expect the US economic system can sustainably increase aggregate demand at a rate much greater than the population growth rate, which until recently was a little under 1% per year. Second, inflation will make the importation of goods necessarily more expensive as commodity prices increase, particularly those goods that have a more or less stable demand year over year, like agricultural and energy commodities. The excess price of imports will yield misallocation of resources until supply far outstrips demand, and the whole thing comes crashing down, just as it did in 2009.
Quantitative easing will ultimately cause unstable prices, initially to the high side, afterwards on the low side. It may initially improve employment prospects, but will cause lower employment in the long run. The Fed fails to achieve either of its mandated goals.
What Should the Fed Do?
Abandon all pretense that they are capable of any long-term sustainable increase in either employment or overall prices, and focus instead on making the currency the best and most stable store of value and medium of exchange it can be. Long-term yields have historically (i.e., throughout the balance of civilization) been roughly three percent, about the same as the natural rate of growth, “e”, which is not a coincidence, the explication of which I’ll leave for another day. Manage the money supply to target long yields at about three percent. Right now, real yields are a bit low, but not far off the mark. Without any further intervention, yields should approach the long-term mean. And then the Fed can just sit back and let individual prices rise or fall as the market provides.
On the policy side, Congress needs to get out of the business of setting wage rates and working conditions. Eliminate the minimum wage. Eliminate mandates providing a costly bag of rights for employees, allowing the market to determine whatever rights and benefits employers provide.
Alas, I know full well that neither of my recommendations have any hope of coming to fruition. The Fed is inept to do anything more than ameliorate short-term and temporary dislocations in economic performance, yet pretends to have within its powers a clear path to economic nirvana. Yet even the Fed admits of its own impotency, if only on an obscure website the public surely almost never reads, and the politicians in it and the Congress ignore:
In the long run, the amount of goods and services the economy produces (output) and the number of jobs it generates (employment) both depend on factors other than monetary policy. These factors include technology and people’s preferences for saving, risk, and work effort. So, maximum sustainable output and employment mean the levels consistent with these factors in the long run.But the economy goes through business cycles in which output and employment are above or below their long-run levels. Even though monetary policy can’t affect either output or employment in the long run, it can affect them in the short run. For example, when demand weakens and there’s a recession, the Fed can stimulate the economy—temporarily—and help push it back toward its long-run level of output by lowering interest rates. That’s why stabilizing the economy—that is, smoothing out the peaks and valleys in output and employment around their long-run growth paths—is a key short-run objective for the Fed and many other central banks.
Indeed. It’d be nice if Bernanke and the boys would learn their own dogma.