Maybe The Fed Is The Problem with Weak Recovery


Maybe Fed Is The Problem

When assessing Federal Reserve Chairman’s Ben Bernanke’s performance, he deserves great credit for his role in preventing a depression.  While controversial, Bernanke’s aggressive moves to provide liquidity to an ailing US and global banking system helped avert an even bigger disaster.  However, there are significant risks in carrying the same policy for multiple years, as expressed by noted monetarist, Dr. John Taylor.  Dr. Taylor’s editorial from the Hoover Institution highlights what those risks are.

Taylor asserts that Bernanke’s monetary policy has not delivered as planned.  When it was started in 2010, Bernanke expected that it would result in economic growth of 4% in 2012.  Actually, we achieved only half of that.  Even though one must say that the collapsing European economy and over-leveraged consumer balance sheets played a role in the disappointing recovery, Taylor makes a good point that it creates uncertainty.

This uncertainty arises from global investors worried about future inflation.  Even though inflation is low now, the Federal Reserve will have to eventually unwind their efforts and that could lead to rising interest rates.  This concern makes industry reluctant to plan for large investments that bring job creation.

The combination of leaving the Fed Funds Rate at zero and participating in large scale asset purchases do result in unintended consequences.  However before explaining those consequences, let’s learn about the role that the Federal Reserve in managing money supply.

Their primary tool in managing money supply involves buying and selling U.S. Treasury bonds.  These bond transactions impact the Fed Funds Rate, which is the interest rate charged by the Federal Reserve to other banks.  This is an important interest rate because all other forms of credit is based on it.  Interest rates on autos, homes, and credit cards rise and fall based on movements of the Fed Funds Rate.

When the Federal Reserve buys bonds, then that drives the Fed Funds Rate down and banks have more reserves that they can loan out to households and businesses.  If the Federal Reserve is concerned about inflation, then they sell bonds, which takes reserves out of the banking system.  While that will decrease lending activity, it will also slow the rate of inflation as money is taken out of the economy.

Interest rates are currently very low for consumers because the Federal Reserve has been extremely aggressive in buying U.S. Treasury bonds.  In fact, they have driven the Fed Funds rate down to essentially zero.  While borrowers will certainly appreciate that, savers will not.

Since savers are punished, that can lead retirees and pension funds to take on more risks in search of higher yields.  Making the wrong moves can easily lead to loss of wealth and would make seniors vulnerable at a time where their income-earning potential is limited.

It also gives banks an incentive to refinance low-performing loans out further into the future.  While the over-burdened borrower certainly appreciates more time to pay off a bad loan, this is not good news for banks and their shareholders, whose bottom-line will be reduced as the risk of non-performance remains, but the rate of return on those poor performance assets are reduced.

Another problem with monetary easing is that it encourages deficit spending.  With interest rates near historic lows, it becomes enticing for Congress to push aside tough decisions on taxes and entitlement spending and just continue running astronomically high deficits.  This is analogous to Chris Credit, who already has run up $20,000 on his credit card to make ends meet.  Then he receives a mailing offering him an extension on his credit limit to $50,000, in addition to a low, teaser annual percentage rate (APR) of 0%.  Therefore, he is more likely to run up his credit card bill than if he received an offer stating that his APR would rise to 20%.

While everyone can see the problem with Chris Credit, there are not enough people, who realize that the U.S. government is in a similar situation.  Even if the Federal Reserve can keep interest rates down for 2, 4, even 6 years down the road.  There will come a time when they must reverse their large scale asset purchases and that could sent interest rates skyrocketing to levels unseen since the 1970s.  High interest rates compromise living standards, as it becomes harder for business to finance job creation and households to afford homes that build up wealth.

If it appears obvious what the right solution is, why is Bernanke so stubborn?  That is because he is rightly concerned that changing monetary policy can easily lead us to deflation.  If the Fed Funds Rate rises as they sell off their bonds, then interest rates will undoubtedly rise.  The economic recovery is weak as it is.  Imagine consumers and businesses having to pay higher interest rates.  That could curtail consumer spending and force businesses to lower prices further in order to rid themselves of inventory and stock.  If this is done on a huge scale, then our overall price level would drop and that is just as bad, if not worse, than rising inflation.

As painful as this course of action would be, the Federal Reserve must start reversing their aggressive monetary policy at a prudent pace.  By keeping interest rates artificially low, it makes it harder to justify deficit reduction because the payoff in terms of lower interest rates is not there.  When politicians see interest rates rise due to unsustainable debt, that might drive legislators back to the table in order to achieve real deficit reduction.

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11 thoughts on “Maybe The Fed Is The Problem with Weak Recovery

    • We do need more dialogue on monetary policy and the Fed. While I do understand Bernanke’s concerns about disrupting our weak recovery, I’m concerned that their actions are making things worse in the long run.

  1. I’m not entirely sure what your argument here is. You start by saying that the fed might be responsible for the weak recovery, but every argument you use to support it warns of potential harm to the economy in the future. Where is the harm the Fed has caused already? How have they prevented a stronger recovery already?

    The arguments sound very close to the 30’s “work of depression” arguments, that we have to take the long hard road through, that anything that helps the economy will do more harm than good in the long run. You’re right that there will come a time when interest rates will rise, and we need to be aware and prepared for it. But Europe has shown us what being conservative with rates and paying down debts in a struggling economy looks like, and I don’t think it’s an example to be followed.

    • Thanks for your comments. My argument is that the Fed’s efforts are contributing to asset bubbles in the U.S. and the world. Notice how the Dow reached a high last week despite questionable fundamentals: weak labor market and significant cash on hand. By distorting the market place through large asset transactions, they have kept interest rates artificially low. Given our debt load, market fundamentals would suggest much higher interest rates. This distorts incentives, discourage saving, and lead investors to overly invest in equities and commodities. While there are some short-term benefits to this strategy, it is loaded with significant downside risks. You bring up a valid point that the argument that I’m advocating was what led us to a depression, so I recognize there’s a downside to tightening money supply. As for Europe, their problem was too much austerity, which was raising taxes and cutting spending. In my opinion, you need to either lower taxes and cut spending or raise taxes and increasing spending. There needs to be some stimulus in times of a weak recovery, so that you don’t risk a recession where your austerity efforts go for naught. As for me, it doesn’t matter which route that pursue, but try telling Congress that. Then when the economy is on firmer ground, then that is when you can pursue more austerity: raising taxes and cutting spending. Does that make sense?

      • Thanks for getting back to me.

        My understanding of bubbles is that they generate extra economic growth until they pop, resulting in a crash. If the Fed’s actions were creating bubbles shouldn’t it result in a stronger recovery followed by another crash? Like you said, distortions have short term benefits followed by downside risks. Unless you’re saying those have already materialized, in which case I’m curious specifically how.

        As to Europe, austerity is simply reducing net deficit spending. If the net effect of tax raises and spending adjustments is negligible the effect on the economy will be too. How could stimulus efforts (tax or spending) have any effect if they’re canceled by equal austerity on the other side?

  2. As for bubbles, they typically result in extra economic growth, but it doesn’t have to be. Asset bubbles pop when investors overestimate the value of an underlying asset. I would say that the increases in the stock market are not consistent with market fundamentals, such as huge amounts of cash going underutilized and a persistently weak job market. I think one of the reasons why stocks have risen is that investors are taking on more risk because bonds are earning such low yields. That’s a direct result of monetary policy that I think will lead to negative consequences in the next three to six months.

    As for Europe and the U.S., we need to be careful about cutting deficits too much and too fast. However, our debt levels, particularly in the US, is at unsustainable levels. That is why it would be dangerous to lower taxes and increase spending. The time to have done that was in 2010, but that stimulus was insufficient. We are getting closer to where we are reaching the breaking point. If not for the Federal Reserve intervening, then we might have already reached our breaking point.

  3. Sweet blog! I found it while searching on Yahoo News.
    Do you have any suggestions on how to get listed in Yahoo News?
    I’ve been trying for a while but I never seem to get there! Thanks

    • Thanks for the kind words, Candice. As for getting on Yahoo News, I believe the key is using key words and multiple social media network platforms to get the word out. In addition to WordPress, I use Facebook, Twitter, Tumblr, and LinkedIn. Also, visuals are important.

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