Why the Fed's QEII Will Not Work

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Imagine a bus packed with passengers. The driver has the gas pedal floored and his left foot hard on the brakes at the same time. The engine is roaring. The bus is vibrating. The transmission is overheating. And, the bus is going nowhere.

Unfortunately for America, the bus is our economy, the passengers are the 14.8 million unemployed Americans, and the bus driver is Ben Bernanke. At the same time the Fed is pouring on the monetary gas with "quantitative easing" (QE), it is pushing hard on the monetary brakes with its "interest on reserves" (IOR) program. And, the economy is going nowhere.

In his November 4, 2010 Washington Post article Fed Chairman Bernanke describes the plans of the monetary mechanics on the FOMC to fit our economic bus with a $600 billion "QE2" supercharger. Unfortunately, applying more QE power won't get the bus moving as long as the IOR brakes are on.

The economic crash that occurred in late 2008 resulted from a plunge in total demand. This was caused by a sharp fall in monetary velocity precipitated by a financial panic. Financial panics always cause the velocity of money to plunge. It is completely rational for people who are worried about whether they will be able to pay their bills to try to hold on to money. However when everyone does this at the same time, monetary velocity falls, total demand in the economy slows, and people lose their jobs.

The Federal Reserve was created in 1913 to handle this very problem. In the face of a financial panic/liquidity crisis, the Fed's job is to increase the supply of money (the monetary base) to meet the economy's demand for liquidity and offset the fall in monetary velocity, thus maintaining total demand and averting a recession.

The Fed did, in fact, dramatically increase the size of the monetary base in late 2008. It had taken 165 months (almost 14 years) for the monetary base to double from $435.7 billion on November 1, 1994 to $871.9 billion on August 1, 2008. Then the Fed put its monetary "pedal to the metal", increasing the base by $64.5 billion in August, $199.3 billion in September, $346.2 billion in October, $210.6 billion in November, and $45.0 billion in December. By January 1, 2009, the monetary based had doubled again in only five months.

This should have worked. The application of this amount of monetary "gas" should have nipped the recession in the bud and even produced an inflationary boom. The reason that it did not was that, on October 6, 2008, the Fed hit the monetary brakes by announcing that it would start paying interest on reserves (IOR) for the first time in its 95-year history.

The available data indicates that it was the Fed's IOR program, not the collapse of Lehman Brothers on September 15, 2008, that crashed the real economy and sent unemployment skyrocketing. Because the two events were only three weeks apart, many people believe that it was the Lehman bankruptcy that precipitated the worst economic downturn since the Great Depression. However, the market data from that period suggests strongly that the real cause was IOR.

A valid way to gauge whether events are "good" or "bad" for the economy is to look at the stock market's reaction to them. The day that Lehman Brothers collapsed, the S&P 500 went down 4.71%. Three days later (i.e., at the fourth market close after the event), the S&P 500 was down by a total of 3.61% from its pre-Lehman close.

At the time of the Fed's IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.

The stock market decline was accompanied by a plunge in employment. Total employment (BLS household survey) had fallen by 1.2 million jobs over the six months April 2008 - September 2008. During the six months after the Fed announced IOR (October 2008 - March 2009) total employment fell by 4.2 million jobs.

The Fed knows that IOR is contractionary. Chairman Bernanke has testified that raising the IOR interest rate is one option for fighting inflation. Two Fed staff economists issued a report in July 2009 ("Why Are Banks Holding So Many Excess Reserves?") that describes how paying IOR at the Fed Funds target rate would stop the "money multiplier" process dead in its tracks. Unfortunately, no one at the Fed seemed to realize that IOR might also stop the economy dead in its tracks (an impact that I predicted in an article published on December 9, 2008 http://www.realclearmarkets.com/articles/2008/12/why_the_economy_is_in_a_tailsp.html).

The creation of new money is supposed to set off an endless chain of transactions. The Fed creates a dollar by buying something from someone and then paying for it by creating an entry in its books. The newly created dollar then appears both as a balance in the seller's checking account and as reserves for the bank in which that dollar is deposited.

In the absence of IOR, there is an incentive for anyone who receives a dollar to immediately pass it on by doing another transaction. There is also an incentive for banks to lend out their excess reserves. This lending produces a "money multiplier" effect that amplifies the impact of the creation of new dollars. If enough new dollars are created and enough new transaction chains are initiated, some of the transactions will involve items that show up in GDP. This is the basic mechanism by which an increase in the supply of money creates demand.

The payment of IOR at an "above market" interest rate (which has been the case for the past two years) short-circuits the processes described above. IOR creates a "roach motel" for money - the dollars go in and they don't come out.

Right now, there are about $9.1 trillion worth of U.S. Treasury bills, notes, and bonds in the hands of the financial markets. The Treasury yield curve starts at 0.12% for 90-day T-bills, and then moves up to 0.16% for 6-months bills, 0.22% for 1-year bills, 2.70% for 10-year notes, and 4.25% for 30-year bonds. These interest rates are set in the market. This means that, on the margin, investors see all Treasury maturities as being equally attractive. The process of arbitrage ensures this.

Now, because the market players have the alternative of buying or selling Treasury securities, the financial markets also arbitrage all other investment opportunities against the Treasury yield curve on the basis of maturity, liquidity, and credit risk. If market players (e.g., banks) saw corporate bonds or small business loans as being more attractive investments, on the margin, than Treasuries, they would sell Treasuries and buy the other investments until interest rates adjusted so that this was no longer the case. Accordingly, we can be sure that banks currently view making an incremental loan as no more (or less) attractive than buying a 90-day T-bill paying 0.12% interest.

Now, here is the problem. Under IOR, the Fed is currently paying 0.25% on what amounts to a one-day T-bill. This is far above the current Treasury yield curve. Accordingly, there is no more attractive investment available to the market than bank reserve deposits at the Fed. Therefore, as soon as a new dollar is created via QE, it goes into bank reserves and then it just sits there. No endless chain of transactions is initiated, no loans get made, no "money multiplier effect" occurs, and no new demand is created.

Just as it makes no sense for a bus driver to floor the gas pedal and the brake pedal at the same time, it makes no sense for the Fed to do QE and IOR at the same time. Unless IOR is ended, the Fed's $600 billion of QE2 will do little to stimulate demand in the general economy.


Louis Woodhill (louis@woodhill.com), an engineer and software entrepreneur, and a RealClearMarkets contributor.  


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