The US Federal Reserve announced yesterday that it would reduce the rate at which it would buy long-term government bonds and mortgage bonds—the long-awaited taper of quantitative easing. But the financial markets have the last word on which way monetary policy has shifted. And as Tyler Durden complained at zerohedge.com, the rise in stock prices and gold prices, and fall in long-term interest rates and the dollar, indicated that the Fed had moved in the direction of monetary stimulus. The reason is that in the financial markets, the reaction to Fed action is always an expectations game. The Fed announced a smaller cut in bond-buying than the financial markets expected, so the markets treated the Fed decision as a move in the direction of stimulus.
Yet the Fed, while tapering more gradually than expected, indicated that it wished it could stimulate the economy more. The majority decision said that as far as the labor market (and the closely related level of economic activity) is concerned, risks had “become more nearly balanced” but that “inflation persistently below its 2 percent objective could pose risks to economic performance.” Since the Fed cares about both the labor market and inflation, the means that overall the Fed thinks there is too little monetary stimulus. And the one dissenter, Boston Fed president Eric Rosengren, said that “with the unemployment rate still elevated and the inflation rate well below the target, changes in the purchase program are premature until incoming data more clearly indicate that economic growth is likely to be sustained above its potential rate.”
What is going on? Though the official statement doesn’t say so explicitly, the discussion of the Fed’s interest rate target makes it clear that if the current labor market and inflation situation were coupled with a federal funds rate of, say 2%, then the Fed would cut interest rates, which would provide a substantially bigger monetary stimulus than moderating the expected taper a bit. So the reason the Fed isn’t stimulating the economy more is not that it thinks the economy is in danger of overheating, but because it doesn’t like the tools it has to use when interest rates are already basically zero. Ben Bernanke said as much when he came to the University of Michigan back in January. Even the Fed doesn’t like QE or making the quasi-promises about future interest rates that go under the name of ‘forward guidance.” So it doesn’t stimulate the economy as much as it thinks the economy needs to be stimulated.
The solution to the dilemma of a Fed doing less than it thinks should be done because it is afraid of the tools it has left when short-term interest rates are zero? Give the Fed more tools. Unfortunately, it takes time to craft new tools for the Fed, but that is all the more reason to get started. (Sadly, even if all goes well in the next few years, this isn’t the last economic crisis we will ever have.) As I have written about here, here, and here, three careful and deliberate steps by the US government would make it possible for the Fed to cut interest rates as far below zero as necessary to keep the economy on course:
- facilitate the development of new and better means of electronic payment and enhance the legal status of electronic money,
- trim back the legal status of paper currency, and
- give the Federal Reserve the authority to charge banks for storing money at the Fed and for depositing paper currency with the Fed.
If the Fed could cut interest rates below zero, it wouldn’t need QE, it wouldn’t need forward guidance, and it wouldn’t wind up begging Congress and the president to run budget deficits to stimulate the economy. And because the Fed understands interest rates—whether positive or negative—much, much better than it understands either QE or forward guidance, the Fed would finally know what it was doing again.