Federal Reserve Chairman Ben Bernanke’s rollout of $600 billion in quantitative easing was a public relations disaster that deserves to be studied in college communications classes. And he could have avoided it by giving up a shiny monetary tool he got in 2008—one that may be at the root of the extended recession.
The Federal Reserve Bank’s shopping spree of distressed debt will, Bernanke claims, create 700,000 jobs over the next two years. But if one of its immediate goals was to inspire market confidence, Quantitative Easing II (QE2) could hardly have gone worse.
In the three months since Bernanke floated the idea of a second round of large-scale asset purchases, the U.S. dollar index has declined by about 5 percent. With household net worth at $54.6 trillion, according to the Fed’s most recent Flow of Funds data, this means about $2.73 trillion of domestic wealth may have vanished in three months.
While much of that fall took place during the period between Bernanke’s QE2 trial balloon in late August and the rollout of the actual program two weeks ago, events since QE2 actually hit the streets have not been encouraging. German Finance Minister Wolfgang Schaeuble called the move “clueless,” and China’s Dagong Global Credit Rating Co. downgraded long-term U.S. debt. The Anglophone financial press tends to dismiss such criticisms as nationalist trash talk, but QE2 cast a glare over President Barack Obama’s Asia junket and made what would ordinarily be considered an average performance—the president failed to close a trade agreement with South Korea and came home with few solid results—into a demonstration of U.S. powerlessness.
The domestic response has been just as gloomy, but for opposite reasons. While yields on U.S. Treasury debt have ticked up (the yield on the 10-year note has risen 0.23 percent since the beginning of November), at home the problem is that QE2 is not creating the lending boom and subsequent price inflation that Bernanke for nearly two years has been trying to conjure through frenzied rain dances. A survey of currencies pegged to or closely aligned with the dollar reveals pockets of robust inflation, but U.S. economic activity is horizontal at best: Retail activity has picked up a little, while house prices, housing starts and mortgage purchase activity are all dropping.
Even Wall Street failed to respond. After a smaller-than-anticipated post-QE2 rally, the Dow Jones Industrial Average has been sliding steadily, and is now lower than it was a month ago. (Though it’s still 1,000 points above its late-August level, suggesting that whatever market excitement QE2 will arouse has already subsided.)
So quantitative easing (large-scale central bank purchases of public and private debt instruments designed to keep interest rates down and increase the flow of money into the economy) is on the verge of striking out twice. Bernanke’s 2010 is ending pretty much like his 2009, except that he’s unlikely to return as Time magazine’s Person of the Year.
Could he have done things differently?
Yes, he could have. There may be no scenario under which Bernanke’s extremely accommodative monetary policy (one which follows the late Milton Friedman’s recipe) would have made a difference in an environment where a broke populace has no appetite for debt and banks see few credit-worthy lending opportunities.
But he could have been spared some of the humiliation if he’d listened to dissenters (including a growing number within the Fed) and tried some other tool to get banks, as the politicians say, lending again.
To be clear: Bernanke would not have gotten banks lending again. He just would have been spared some shame.
The Fed is two years into an experiment that is new in the central bank’s 97-year history. It is paying banks interest on reserves. According to Fed and independent analysts, interest on reserves is a powerful new tool that allows the Fed to create all the new money implied by QE2, while preventing that money from flooding into the private sector and causing uncontrollable inflation. “We can have an enlarged balance sheet and not have a long-term inflation problem,” New York Fed President William Dudley told CNBC on Tuesday. “This is because we can pay interest on excess reserves, which can moderate credit demand. We did not have this tool before 2008. So if you're reading the old textbooks about money and banking, you would be very concerned.”
Like many bad ideas, interest on reserves originated with Milton Friedman, but it is being applied in a way the great Chicago economist and monetary theorist did not foresee. Friedman advised payment of interest on those reserves banks are required by law to keep. The Fed is paying interest on both required and excess reserves—the latter of which have ballooned in the last 18 months and now stand at about $1 trillion, a level that is unique in U.S. banking history.
Comments like Dudley’s above, backed up by Fed studies [pdf] and both Fed supporters and detractors, suggest interest on reserves (IOR) prompts banks to keep that money locked up in vaults rather than lending it out. If you are getting an interest rate higher than inflation from the Fed, the argument goes, you will keep the money parked where it is.
That raises a simple question: Rather than creating new money through QE2, why not reduce or eliminate the interest on reserves, and let the excess reserves flow out into the economy?