Sunday, March 11, 2012

Is Fed Policy Twisted Or Merely Sterile?

Published in The Tennessean, Sunday, March 11, 2012

and Forbes with archives.

by Richard J. Grant

Federal Reserve officials continue their search for new and improved methods to invigorate our underperforming economy. According to Jon Hilsenrath in the Wall Street Journal, the Fed's latest idea is to “print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates.”

Such a program would change the composition of assets and liabilities held by the Fed. It would also increase the demand for long-term bonds, thereby holding down long-term interest rates a little longer. But the short-term borrowing that finances it would also bid up short-term interest rates. In this regard, it would have the same effect as the recently implemented version of “Operation Twist” in which the Fed has sold short-term securities and used the cash to buy long-term securities.

But why doesn't the Fed just create money to buy whatever it wants? Fed officials are as aware as anyone else that monetary inflation pushes prices higher than they would have been “all else equal.” That is why they won't let all else be equal.

As years of malinvestment – bad or inappropriate investments – began to unwind during 2008, the Fed had to decide quickly whether and how to respond. It purchased unprecedented quantities of mortgage-backed securities and other low-quality assets that threatened the solvency of many financial institutions. Those financial institutions received cash while the “toxic assets” moved onto the Fed's balance sheet.

When the Fed created the cash to purchase those assets, it created it out of nothing. Central banks do that. But when analysts saw the quantity of base money double during the last quarter of 2008, they were justifiably concerned about the increased likelihood of future price inflation.

All else equal, such a rapid increase in the quantity of base money would soon after result in a rapid and general increase in prices throughout the economy. The first symptoms would be dollar weakness and rising commodity prices. This would eventually show up as rising consumer prices once we had worked our way through the recessionary adjustments and economic activity began to pick up. The size of the increase would, of course, hasten the symptoms of inflation.

But no such rapid increase in consumer prices has yet occurred. During 2008, the Consumer Price Index rose almost 5 percent and then fell back by the same amount. Since then, although some commodity prices have been strong, the CPI has not risen by much more than 3 percent per year. Clearly, all else is not equal.

When the quantity of base money grew rapidly (it has tripled since mid-2008), its growth in dollars was almost matched by bank reserves. Banks now hold 18 times the amount of reserves that they held in mid-2008. Not coincidentally, in late 2008 the Fed began paying interest to banks for holding their reserves. Currently, banks receive one-quarter percent interest for making a risk-free loan to the Fed.

This sounds rather similar to the new and improved program being considered by Fed officials. It also sounds similar to “Operation Twist.” All three programs are structured to increase demand for some long-term asset by sending a flood of money in one direction while “sterilizing” it against inflation by retaining or pulling back an equivalent amount of money at the same time.

The Fed continues to bury its talents.

Richard J. Grant is a Professor of Finance and Economics at Lipscomb University and a Senior Fellow at the Beacon Center of Tennessee. His column appears on Sundays.

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Copyright © Richard J Grant 2012