A nice article in the Financial Times by Wolfgang Munchau, “Double jeopardy for financial policymakers,” discusses the Federal Reserve’s move to quantitative easing. There has been some mention of this in the media, as a Bloomberg story from last week indicates, but it hasn’t gotten the attention it deserves. The use of quantitative easing is an extreme move, a sign the Fed is desperate.
Some quick background from the Bloomberg piece:
The Federal Reserve’s efforts to rescue the U.S. from financial collapse risks the eclipse of the central bank’s benchmark interest rate as the most important signal of monetary policy.
Record injections of liquidity have driven the overnight lending rate between banks to less than half the 1 percent target set by officials last month. The gap is shifting investors’ focus toward the amount of money in the banking system as a better gauge of Fed intentions.
The Fed’s failure to meet its target risks pricing billions of dollars in short-term debt at interest rates lower than the Federal Open Market Committee intends. It also makes it harder for traders to bet on the central bank’s future course of monetary policy….
Fed Vice Chairman Donald Kohn said today the central bank is simultaneously reducing interest rates and expanding its balance sheet in quantitative easing, while not adopting one strategy “in favor of another.”…
“There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,” said former St. Louis Fed President William Poole, now a senior fellow at Cato. “Monetary policy works best when the markets understand what the central bank is doing.”….
“It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,” said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.
The object of this exercise is to lower the long end of the yield curve, as Bernanke described in a paper on Japan.
Am I the only one who finds this development ironic? The Fed, which used money supply targets with enormous success in the Volcker era, renounced them when they started behaving inconsistently with historical patterns as banking deregulation created all sorts of forms of near money. To me, that never argued for abandoning the use of various money supply measures, but perhaps de-emphasizing them out of necessity for a few years while throwing the brightest minds at the Fed on the problem to understand how to make use of them in a deregulated world. Instead, Alan Greenspan had the Fed whizzes studying…..stock prices. (I am NOT making this up, see the front page of the Wall Street Journal, May 8, 2000. All my doubts about Greenspan were confirmed then).
Now we are back to using money in a brute force fashion, but with no benchmarks. Lovely.
Now to the key section from the Munchau article:
Statisticians distinguish two types of errors: type one and type two. Suppose we believe that another Great Depression is about to happen. A type-one error would be to reject our depression scenario when it is true, while a type-two error would be to accept it when it is false.
The US Federal Reserve’s policy is about avoiding a type-one error – underestimating the threat of a depression – at all costs. I was quite surprised last week – though perhaps should not have been – when I learnt that the Fed had quietly adopted a policy of “quantitative easing”.
The Fed conducts open-market operations normally with the goal of keeping the actual Fed funds rate close to the target rate set by the Fed’s open-market committee. The Fed funds rate is the rate at which banks lend their balances to each other overnight. But, more recently, the actual Fed funds rate has fallen much below the target rate, which is 1 per cent. Under a strategy of quantitative easing, the Fed does not care about the rate. The goal is to increase the money supply, by swamping the Fed funds market with liquidity. The calculation is that this would give banks an incentive to buy higher yielding securities, which would reduce long-term interest rates, over which the central bank has no direct influence.
For a central bank, this is comparable to the deployment of the nuclear option – your last or last-but-one policy option. Ben Bernanke, the chairman of the Fed, once co-wrote a paper on the subject of what a central bank can do when interest rates hit the “zero bound”* – a zero rate. The answer is that there are a few options, quantitative easing among them. It is interesting, though, that he has already deployed his weapon of mass desperation while still some distance away from the zero bound.
The US policy establishment regards this crisis principally as carrying a “one-tailed”, or one-sided, risk of a deflationary depression, to be avoided at all costs. But there are also grave risks associated with making a type-two error. A subsequent rise in US inflation could trigger a mass flight out of dollar assets and a large rise in US market interest rates, followed by a huge recession. The main difference is that the policy options would be a lot more constrained under such a scenario. In fact, a type-two error could also give rise to a depression – only later. I still think it is best to treat the crisis as an event with a “two-tailed” risk.