Bernanke Is Taking a Risk With QEII
Monetary Policy: One big loser in Tuesday's GOP tidal wave was someone who didn't even appear on a ballot. It's Fed Chairman Ben Bernanke, who'll face greater scrutiny from a skeptical Congress about his policies.
Since Bernanke took office in February 2006, his record has been mixed. Perhaps out of respect for his predecessor, the "Maestro" Alan Greenspan, Bernanke initially kept raising interest rates. Then, as it became clear the economy was tanking, he reversed course and began easing - aggressively so.
A scholar of the Great Depression's monetary policy, Bernanke was keen not to duplicate the mistakes made back then, when the central bank let the money supply shrink by 30%, helping doom the economy to a decade-long deflation. By the end of 2008, he had pushed interest rates down to zero - an unprecedented easing in response to the financial meltdown.
Did it work? It seems so. As noted here in early 2009, a recovery was baked in the cake. And indeed, by that June, the economy had begun to recover, though in fits and starts and with no job growth.
Even so, starting in 2009, the Fed embarked on what it called quantitative easing - a fancy term for creating money out of thin air. Over a little more than a year, it bought more than $1.7 trillion in assets, mainly U.S. Treasury and agency debt.
Today, U.S. bank reserves are close to $1 trillion - an enormous amount compared with the normal $4 billion to $8 billion.
On Tuesday, with the economy struggling and many Fed officials still worried about the specter of deflation, the Fed embarked on a second round of quantitative easing, dubbed QE2. The plan is to spend $600 billion to buy even more government debt, hoping to push down long-term interest rates to boost consumer spending, home sales and business investment.
We appreciate the Fed's dilemma. Interest rates are already at zero, so there's nothing left to cut. That leaves gimmicks such as quantitative easing as the only tool. But we're also concerned about the unprecedented amount of money that's being created - funds that won't be easily taken out of the banking system once inflation takes off.
With its latest bout of quantitative easing, the Fed will have created $2.5 trillion out of the blue. Yet we've had no job growth since it began. So calling it "stimulus," as some do, is simply false.
What the Fed calls quantitative easing used to be called monetizing the debt - printing money to cover a profligate government's debts. It was anathema to a generation of economists. But not today. Given our 9.6% unemployment and a fear of deflation, lots of smart people think QE2's the right thing to do.
But how real is the deflation threat? Not very. Reuters quotes a San Francisco Fed study that puts the threat of actual deflation over the next three years at 5% or less. Others are in the 20% to 22% range.
As for inflation, it's already here. The dollar has plunged in value, raising prices on everything we buy overseas. Commodity spot prices hit an all-time high in September and continue to rise. Gold? Also at record highs. Oil? It has doubled in a year to $83 a barrel.
Other common goods - from rubber to sugar to copper to rare earths - are surging, with some near all-time highs.
It's only a matter of time before these prices are felt in the cost of consumer goods. At present, home prices are distorting inflation figures. Year over year, housing costs have fallen 15 straight months.
The risk? Once the economy takes off, inflation may spike. And once inflation gets imbedded in the economy, it's tough to get rid of. If you don't think so, go back and review the history of the 1970s.
Bernanke is as smart as they come. But adding another $600 billion to the $1 trillion the Fed has already stuffed into the banks does nothing to boost economic activity.
And if inflation returns with a vengeance to decimate the economy as it did in the 1970s, he'll come in for tough questioning by a new GOP-led Congress that isn't as enthusiastic about quantitative easing as the Democrats.
