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By Roger Farmer
Ben Bernanke, US Federal Reserve chairman, has announced that the Fed is about to go on a $600bn spending spree by buying $75bn of treasury bonds every month for eight months. Not all of the members of the Federal Reserve Open Market Committee agree that a second round of quantitative easing is a good idea. Thomas Hoenig of Kansas City, Jeffrey Lacker of Richmond and Charles Plosser of Philadelphia have expressed concerns that QE2 could lead to inflation through excessive monetary expansion and that it might inflate a new stock market bubble. They may be right.
I have argued in this Forum that more QE can create jobs and prevent a second Great Depression. But it matters how the policy is implemented. The Fed should buy stocks not bonds. And rather than commit to a fixed programme of stock purchases, the Fed should use its market power to stabilize swings in the stock market and smooth out bubbles and crashes.
US consumers and business investors reduced spending in 2008 because the value of houses, factories and machines plummeted. The housing bubble burst and the stock market fell at the same time. Currently, investors hold more than a trillion dollars in excess reserves at the Fed because they are afraid of a repeat performance.
QE is widely perceived to be the same thing as increasing the money supply. But it is not. Mr Bernanke has argued that the first round of QE was effective because it increased stock market wealth. That is an argument I have made in previous opinion pieces in the FT and two recent books. When people feel richer, they spend more. That creates jobs.
But the current problem is not that the stock market is undervalued. The Dow is now back at the level it attained immediately before the 2008 crisis. The problem is that investors are fleeing from risk and are demanding safe assets. The Fed is uniquely positioned to provide a safe haven for investors by buying risky securities from the public and replacing them with interest bearing deposits at the Fed.
What kind of risky assets should the Fed buy? Mr Bernanke plans to purchase treasury bonds. The Bernanke plan could prove costly when inflation reappears because the price of treasury bonds will fall when interest rates rise. And when the Fed loses money, its political independence will be compromised. That is why a better plan would be to buy stocks. This policy would provide a more effective exit strategy, since, when inflation reappears, dividends and stock prices will rise and rather than lose money, the Fed will stand to make substantial gains.
Buying stocks rather than bonds is not an untested policy. The Hong Kong Monetary Authority tried it successfully in 1998 and this month the Bank of Japan announced that it would invest in stocks and real estate. Although I am encouraged that the BoJ has embarked on a strategy that I have advocated for some time, the Bank has not announced how it plans to manage its portfolio. Although it is important to buy stocks rather than bonds, it is also important that a central bank should buy and sell stocks with the goal of reducing private sector risk. How might this be achieved?
Historically there have been two ways in which the Fed has implemented conventional monetary policy. One is to buy and sell treasury bills to control the rate of growth of the money supply. The other is to buy and sell treasury bills to stabilize fluctuations in the interest rate.
QE is a new, unconventional monetary policy and, like conventional monetary policy, there are two ways that it can be implemented. One is to buy securities in fixed amounts each month. That is what Mr Bernanke plans to do, although he proposes to buy bonds rather than stocks. The other is to buy and sell shares to stabilize fluctuations in the stock market. I propose this second strategy.
If the Fed were to announce that the Dow would not be allowed to drop below 11,000 over the next three months, for example, it would provide the confidence to private investors to move back into the market and spend some of the $1,000bn in excess reserves that are sitting in the banking system. But guaranteeing no downside to stocks is not, on its own, a good idea. The Fed must also limit swings on the upside. If QE simply fuels another unsustainable asset market bubble it will have made the problem worse, not better. Just as conventional monetary policy stabilizes swings in interest rates, so unconventional monetary policy must stabilize swings in asset prices.
Related reading:
QE2 is about asset prices, not the economy - Gavyn Davies, FT
Latest news on central banks - FT
Money Supply - FT blog on central banks
FT Alphaville’s posts on QE - FT Alphaville
Prof Farmer is chair of the economics department at UCLA and the author of two books on the current global economic crisis. How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies, is written for the general reader and specialist alike and Expectations, Employment and Prices is written for academics and professional economists. Both are newly released by Oxford University Press.
© Roger E. A. Farmer
Tags: Ben Bernanke, Federal Reserve, Quantitative easing
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