It is time the Fed realized that Quantitative
Easing is ineffective (Opinion Article)
Faced with a zero lower bound (ZLB) overnight interest
rates, monetary policy by the Fed took an unconventional turn. The central bank
embarked on massive asset purchase. Known as Quantitative Easing (Q.E), the Fed
bought back government debt instruments by creating new bank reserves. Q.E was
justifiable in the middle of the last recession, but it is definitely not suitable
as a continuing monetary policy tool in the manner that recent announcements by
the Fed seem to suggest.
In a testimony before a joint Congressional Committee on
Wednesday, Fed Chairman Ben Bernanke indicated that the bond purchase that is
now in its third round could continue for some time. “Monetary policy is
providing significant benefits,” Bernanke told the Congressional Joint Economic
Policy. Minutes of the Federal Open Market Committee (FOMC) latest meetings
released on the same Wednesday also emphasized that the decision to scale back
the $85 billion asset purchases will depend on the performance of the economy. This
is likely to happen when the unemployment rate goes below 6.5%.
The continued asset purchases could further
weaken the dollar against major trading partners.
A number of economists did raise this issue when the Fed
first came up with the idea of Q.E way back in late 2008(Wallsten and Reddy 2).
Economists Joseph Stiglitz and Paul Krugman then saw additional fiscal stimulus
as the only effective way through which the economy could be restored. That the current economic problem is a fiscal
one needing a fiscal solution is held even by some members of the Fed (Reuters
2). Sometime in late March, Richard Fisher who is the President of the Dallas
Federal Reserve suggested that it was time the Fed scaled back the purchase of
collateralized debt obligations. He cited improvements in the housing market to
support that position.
There is too much unused liquidity in the
market.
The uncertainty surrounding fiscal policy direction is
making it difficult for the market to utilize the liquidity created from more
asset purchases. "We
... know that monetary policy is necessary but not sufficient to achieve full
employment because it's also a function of fiscal policy. And there lies the
problem," Richard Fisher said (Reuter 2). These sentiments are shared by
the President of Philadelphia Fed, Charles Plosser.
Is there an alternative for the Fed
in the current circumstances?
Professor Michael Woodford of Columbia University has challenged
the premises undergirding the supposed effectiveness of Q.E. Professor Woodford
does this by making an analytical distinction between what he calls ‘pure’ Q.E
and operation twist. In the former, the Fed purchases short term treasuries by
creating new reserves thereby increasing its balance sheet. A point reaches
where banks are indifferent to holding reserves or treasuries. This is exactly the point we are in given that
increased liquidity does not lead to any changes in main street economic
activity. Operation twist on the other hand is where the Fed uses short term
treasuries to buy long term treasuries. In contrast to how the Fed sees it,
Woodford argues that the two are perfectly substitutable such that given one
for the other does not change anything.
In contrast to Q.E, Professor Woodford suggests that a
kind of communications strategy as a monetary policy tool would be more
effective in ZLB situation than Q.E. Under this approach, the Fed would simply
communicate its intention to continue an accommodative monetary stance even
when the ZLB is no longer binding.
Works Cited
Reuters. “Fed’s Fisher repeats call to reduce Bond
Buying.”16 March 2013.
Wallsten, Peter and Sudeep, Reddy. “Fresh Attack on Fed
Move.”The Wall Street Journal 15 November 2010.
Woodford, Michael. “Methods of Policy Accommodation at the
Interest-Rate Lower
Bound.” Paper Presented at Federal Reserve Bank of
Kansas Economic Policy Jackson Hole
Symposium (2012).
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