QE is Pushing on a Rope: Not the Solution to Weak Private Demand

December 19, 2013

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President Kocherlakota of the Minneapolis Federal Reserve (and other members of the FOMC) has argued recently that tapering Fed purchases of bonds would slow the economy. This assumes that interest rates would rise and that asset values (bond prices and stock values) would fall, reducing aggregate demand and economic growth. But with uncertainty about economic policy ranking fourth out of 75 potential items as the most important problem facing small business owners and a 40-year record 37 percent of those citing the current period as not a good time to expand because of the political climate, expected future returns might benefit from a reigning in of a policy that has taken us into uncharted and not-well-understood territory.

Kocherlakota suggested that we should be doing even more bond-buying, adding trillions more to the Fed’s portfolio. Given that interest rates are about as low as we can make them, it is hard to see how this, per se, would help. Indeed, it is hard to make the case that adding a trillion dollars to the Fed’s portfolio this year has done much to improve employment (the unemployment rate has declined mostly because of workforce departures, not job creation). The liquidity the Fed has provided has done little to stimulate the real economy but has certainly “inflated” bond, stock, real estate and gold prices.

Kocherlakota said the Fed should do “whatever it takes” to bring the economy back to full employment quickly, even if it meant higher inflation. So, with trillions of dollars of excess reserves sitting at the Fed due to a lack of demand for loans based on an uncertain economic future, he thinks increasing that amount by “whatever it takes” would change this? He suggests that reducing the 0.25 percent interest paid on excess reserves might do the trick. Really? He thinks that bankers prefer that 0.25 percent to a good 6 percent business loan but cutting that to, say, 10 bp will produce loans? It’s not a supply of credit problem. Cutting the rate will definitely hurt bank profits, but will not generate more loan demand. Banks are forced to re-price their long term loans off an artificially depressed 10 year Treasury yield, further reducing profits. The notion that credit growth is slow because lenders are irrationally reluctant to lend is nonsense. The October NFIB survey of its 350,000 member firms puts the percent of owners with no interest in a loan at record high levels (53 percent, plus 13 percent who didn’t even answer the question on credit needs). QE will not fix that and as the Fed’s portfolio grows to incomprehensible levels, even more uncertainty will be produced. Only 4 percent think the current period is a good time to expand (40 year average is 16 percent), and 68 percent view it as a bad time (a record 37 percent of those blame the “political climate”). This is a clear signal that loan demand is depressed.

In this environment, “more” is definitely “less” in terms of the impact of more QE on the economy. Fancy simulations based on assumptions of policy-makers stretch the credibility of the arguments made in favor of even more QE. Reducing, eliminating QE, a move toward “normalization” (a term frequently used but not defined) might well have a positive impact on the economy by reducing uncertainty and restoring market pricing. The evidence on QE hardly argues for more when trillions of excess reserves now sit fallow. And undertaking more QE because the imprudent guidance set by the Fed for the unemployment and inflation rates suggests we should do more is a bad idea. It was a bad idea to set these goals when the targets are driven by such a wide variety of forces. If QE hasn’t worked so far (certainly not with any substantial impact), piling trillions more on trillions already not used can’t help, but sets us up for big problems with the “normalization” that is promised in the indefinite future.

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