Has the Fed Eased Too Much?
The Federal Reserve's latest easing move, a $600 billion purchase of US government bonds, known as QE2, has elicited much criticism from Congress and some members of the Fed's own policy board. It has been labeled by critics as inflationary and contrary to the Fed's mandate to pursue price stability. There are some guides - though they are controversial - for determining when a central bank should stop easing after a financial crisis such as occurred in 2008. In light of those criteria, considered here, it is not clear that the criticism of QE2 is valid.
Central banks can be and need to be large buyers of government debt under three conditions: First, after a financial bubble collapses, when a surge in the demand for liquidity coincides with a surge in government borrowing undertaken to finance fiscal stimulus. Second, when central banks have reached a zero interest bound in which asset purchases are the only measure available to avoid the risk of deflation. If deflation takes hold, it boosts the real interest rate and causes a destabilizing further boost in liquidity demand and deflationary pressure. Finally, when private borrowing collapses under the deflationary zero-bound scenario - as it has done in the United States since 2008. Higher public borrowing has offset lower private borrowing, total borrowing has remained flat, and upward pressure on interest rates has not resulted from crowding out.
The limit for a central bank's buying of government debt is reached when deflation fears dissipate and inflation or growth expectations rise sufficiently to create lower real interest rates that stimulate a rise in private borrowing. Then, the total stock of new debt issue that markets must absorb rises rapidly and interest rates rise. If the central bank continues to cap nominal interest rates by further purchases of government debt, inflation rises and a limit on central bank purchases is reached, given that the central bank adheres to its "low and stable inflation" mandate. The European Central Bank and Bank of England have reached that limit, and the Federal Reserve may be getting close, unless the surge of uncertainty tied to Arab Spring uprisings and Japan's negative shock overwhelm and reverse recovery momentum.
Critics of the Fed's QE2 program claim that it pushes the Fed into the inflationary stance described above. While that outcome may eventually emerge, so far the QE2 program has arrested last summer's deflation scare while - with the help of the second fiscal stimulus enacted in December 2010 - boosting equity markets. Since the risk surge tied to higher energy costs and Japan's nuclear accident, interest rates on ten-year Treasury notes have dropped by about 30 basis points, suggesting that the Fed's QE2 stance has not disturbed the anchor on inflation expectations even as headline inflation rises. Absent QE2 and stimulus 2, which will end in the coming months, interest rates and prospective US growth would be even lower.
The Fed's sharply criticized QE2 could prove to be serendipitous - or not if risk factors disappear. The bottom line: the right amount of central bank purchases of government debt is very hard to determine and highly variable. There are no hard-and-fast rules to follow. It may turn out that central banks have to threaten inflation to avoid deflation and then abruptly reverse policy if core inflation starts to rise.
The experience of persistent Japanese deflation over the last decade coupled with a timid Bank of Japan comes to mind. Reversing policy too quickly brought back persistent Japanese deflation after 2000. Alternatively, reversing stimulative monetary policy too slowly, as China arguably has done since mid-2010, risks a rise in inflation and inflation expectations. That outcome can force an abrupt monetary tightening and the risk of weaker growth.
As was the case a year ago, attitudes about the correct stance for Fed policy may change rapidly if growth slows at midyear and/or risks from higher energy prices and Japan's nuclear-earthquake tragedy persist. The resilience of US and European equity markets has been impressive on the notion that - in the United States - QE3 could/would emerge if recovery risks surfaced, while in Europe investors are counting on an orderly assumption of sovereign risks by the EU.
Neither outcome is certain, however. The Fed will be more reluctant to signal a more accommodative stance, as Chairman Ben Bernanke did last August at Jackson Hole, for two reasons. First, the internal resistance to easing at the FOMC has grown into pressure for early tightening; second, external pressure from a Congress now openly hostile to QE2 remains strong.
The bar for even hinting at QE3 is much higher this year, while prominent US equity analysts - Barton Biggs and others - are assuming that the Fed would respond quickly with additional monetary ease given any economic slowdown or a stock market sell-off. The higher-bar scenario suggests a real limit on what central banks can do.
Ad hoc easing is a drug that provides temporary - sometimes dramatic - relief to markets, as clearly illustrated by the strong stock market rebound since last August. However, once the effect wears off, another, possibly larger, dose is required to keep things going. In the current hostile environment, the Fed may have reached the limits of its ability to keep markets elevated.
