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The Fed's $600bn bond spree is not wrong, just not enough. The US economy needs a target of 3-4% inflation to get moving
The recent economic data leaves little doubt that the economic recovery in the United States is anaemic at best. There was much celebration over the October jobs report, which showed a gain of 151,000 jobs. This was better than the near-zero number anticipated by most economists, but should hardly provoke cries of joke. The economy must create 100,000 jobs a month just to keep even with the growth of the labour force, which means that it will take more than a decade at this pace to get back the 7.5m jobs lost to date.
The picture painted by the data on third-quarter GDP, which was released the prior week, was even bleaker. Most reports focused on the 2.0% growth number, which was slightly higher than had been expected. However, these reports missed the fact that most of this growth was due to the extraordinary pace of inventory accumulation in the quarter. The rate of accumulation in the third quarter was the second highest ever, adding 1.4 percentage points to growth for the quarter. Excluding this jump in inventories, the economy grew at just a 0.6% annual rate in the third quarter. If inventory growth returns to a more normal level, fourth-quarter growth will likely be negative.
The Fed's decision to try another round of quantitative easing must be understood in this context. The US economy is operating far below capacity and is not likely to return to potential output any time soon without some outside boost. The Fed's decision to buy $600bn in government bonds over the next eight months is a step in this direction.
This is a followup to an earlier round of quantitative easing announced at the beginning of 2009, in which the Fed bought $1.25tn of mortgages backed securities and another $300bn of government bonds. That move helped to bring down long-term interest rates and stabilise the economy at a time when it was sliding rapidly.
The new move should also help to lower interest rates although the effect is likely to be limited. With long-term interest rates already at extremely low levels, it is unlikely that the Fed's new bond purchases will lower them much further. A decline of 30-40 basis points would probably be the best that can be expected. This would lead to a somewhat smaller decline in private-sector rates, like mortgage interest rates and corporate bond rates.
This will help to promote growth, but it is not likely to qualitatively change the basic economic picture. A modest drop in mortgage interest rates will not revive the housing market, nor will lower interest rates lead to an investment boom. The positive stock market response may lead to some additional consumption through the wealth effect, but here, too, the impact is likely to be modest.
The largest effect will likely be on the value of the dollar. With the Fed quite explicitly determined to keep interest rates low, investors are likely to seek alternatives to dollar assets. This will cause the dollar to drop, which will, in turn, improve the US trade balance. The downward drift of the dollar is something that must happen and a second round of quantitative easing may bring the drop about sooner.
Still, the Fed's move is a disappointment. Given the severity and the duration of the downturn, $600bn in bond purchases is a very modest measure. The more effective policy that the Fed opted not to pursue is inflation-targeting. If the Fed targeted a moderate rate of inflation (eg, 3-4%), it could change expectations and therefore behaviour.
If businesses expected that prices for most goods and service would be 12-16% higher in four years, then they would be far more willing to undertake investment "“ even in the current economic climate. A moderate rate of inflation would also help households escape from indebtedness. While their debt is fixed in nominal terms, if inflation raised wages by 15%, then it would reduce the burden of the debt by 15%. This should also boost consumption and growth.
House prices should also rise roughly in step with inflation. A 15% rise in prices over the next four years would pull many people out from being under water with their mortgages and personal debt. It would add trillions of dollars to homeowners' wealth.
The Fed's holding of debt also has another benefit that has received far too little attention. Insofar as the Fed holds the government's debt, the interest payments on this debt pose no burden for the government since the interest received by the Fed is refunded right back to the Treasury. Last year, the Fed refunded $77bn in interest to the Treasury, an amount equal to nearly 40% of the government's net interest payments. The Fed's decision to buy and hold debt prevents the interest on this debt from posing a burden to the Treasury.
In short, QE2, as this second round of quantitative easing has been dubbed, is a positive step in the current economic situation. Unfortunately, it is not nearly enough to fully counteract the severity of the downturn.
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8 November 2010 9:42PM
You defend the indefensible, Mr Baker
If the Fed wanted to spend $600 billion it should have invested directly in projects that offered some long term benefit to society, instead of simply giving yet more liquidity to people who have a track record of abusing the privilege for short term speculative gain (or loss).
Where have supposedly educated people who still peddle this nonsense been for the last three years?.
8 November 2010 10:28PM
The downward drift of the dollar is something that must happen
Because those of us who lived within our means, avoided debt and saved money when we could deserve to be punished for it.
House prices should also rise roughly in step with inflation. A 15% rise in prices over the next four years would pull many people out from being under water with their mortgages and personal debt. It would add trillions of dollars to homeowners' wealth.
Because those of us who thought "Housing prices are in a bubble, so I'll keep renting until prices drop back down to the traditional 'Buy a home worth three times your annual salary' formula" also deserve to be punished for it.
8 November 2010 11:45PM
It looks as if the author really is not with it. He has not been following the arguments such as whether or not this constitutes a de facto devaluation strategy and whether or not competitors will accept having their currencies correspondingly revalued; the suggestion that cheap money chasing up asset values is what got us into this mess in the first place, so he is offering the patient more of what caused the illness and so on. Doubtless those who have been following the debate will have more to add.
9 November 2010 12:41AM
Remember the pools winner Viv Nichols,the Spend,Spend,Spend drama made about her after she had blown the lot-similar economics to Mr Baker.
9 November 2010 1:46AM
Whenever I hear a term like "quantitative easing", I know some BS is coming!
Methinks "banker enrichening" would be far more appropriate term for what is being done.
If you have not been storing your savings in metals, what are you waiting for?
9 November 2010 4:54AM
@JenniferAbel
Because those of us who lived within our means, avoided debt and saved money when we could deserve to be punished for it.
Frankly, yes. You didn't do those things to benefit anyone else. With luck, fear of inflation will make net savers get out there and spend, which will benefit the economy.
9 November 2010 5:16AM
Just because your beard matches Ben's, you don't have to ape his ideological pipe dreams.
Playing with monetary policy, while rates are close to zero and the country is in a liquidity trap, has no effect on the economy whatsoever.
Deficit spending by the Government is the only thing keeping a pulse on the US economy.
Bernanke can influence trading decisions and market sentiment but that's about all he can do. It may have a short term impact on the economy, maybe boost a little credit expansion. It is unlikely to stick. When the Feds words are proven hollow, the trades will reverse and the US economy will be back to square one.
Aggregate demand will be boosted only by increasing fiscal spending and widening the deficit. Every major player knows it. Power and control politics of ultra wealthy conservatives preclude the one activity that will save the day. Notice, they are not a stupid as the Tories to actually reduce the deficit.
Epic Fail, a disappointing and misguided article.
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