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Fed Analysis:The Costs of More Quantitative Easing

Aug 2, 2012 || Blu Putnam || No Comments

The Federal Reserve is feeling tremendous pressure to do more to stimulate a lackluster economy and encourage more rapid job growth.  Unfortunately, there is little it can do now – indicated by yesterday’s FOMC statement that was largely unchanged from June.   Moreover, even the current near-zero rates and distorted yield curve may have higher costs for the economy than are generally appreciated.

The Federal Reserve acted aggressively in the fall of 2008 and early 2009 with massive quantitative easing (QE1) to avoid a freeze-up of the banking system and prevent a full-fledged depression.  QE1 probably saved 5 percent to 10 percent of real GDP over the 2009-2010 period by its fast action to stabilize the banking system, and QE1 is the main reason economic growth resumed in the third quarter of 2009.  By contrast, the extended period of a near-zero federal funds rate coupled with QE2 and Operation Twist that lowered bond yields and flattened the yield curve is now probably hurting economic growth.

Effectively, QE2 and Operation Twist provided lower borrowing costs to corporations and took interest income away from savers and retirees. The corporate decision to invest has in no way been constrained by the level of rates.  Corporations are flush with cash.  Their problem is a lack of confidence in the future, given the US has no long-term government tax or spending policy and is facing a fiscal cliff in 2013 which is highly likely to cause a recession if the US Congress fails to act.

On the consumer side, savers, retirees and anyone with a conservative portfolio that depends in part on interest income for spending has been hurt badly, and they have had to cut consumption in response to their lower incomes.  That is, current Federal Reserve policy is depressing consumption from one segment of the economy and is powerless to create the clarity in government tax and spending policies that are needed to improve corporate confidence and stimulate investment.

Watch a video of Putnam’s analysis 

There are long-term costs related to QE2 and Operation Twist, too.  The Federal Reserve has distorted the natural shape of the U.S. yield curve, by depressing the real (inflation-adjusted) return on longer-term U.S. Treasury securities, by its massive asset purchases.  In all, the Federal Reserve now has total assets of close to $3 trillion and it needs only about $1 trillion to run traditional banking and rate policy.  The serious long-term challenge is how this massive balance sheet will impact future policy.

To exit its emergency mode policies would imply the sales of U.S. Treasuries and mortgages at the same time as the federal funds rate would be raised back toward a normal premium relative to inflation.  The Federal Reserve could delay asset sales by paying a higher interest rate on excess reserves as it raised the federal funds rate, but this would reduce the Fed’s own profits and cash flow.

The exit from quantitative easing is likely to be exceptionally difficult and potentially disruptive, lowering long-term average real GDP growth during the transition period back to a more normal monetary policy.  In short, the “insurance” the Federal Reserve has bought with QE2 and Operation Twist to encourage employment growth may have quite substantial long-term economic growth costs.

Our 2013 and 2104 economic growth projections are lower by about 2 percent each year compared to what they would be (1.5 percent versus 3.5 percent) if the country had both a long-term fiscal policy plan and if monetary policy was not stuck in emergency mode and distorting the natural shape of the yield curve.  In short, the lack of confidence by corporations and consumers is not helped either by the lack of fiscal clarity or the continuation of emergency monetary policies given that the economy has been growing steadily for 12 consecutive quarters.  Faster growth is likely only with long-term policies in which the markets can have confidence.