The Fed actually did it.
The US central bank ceased the large-scale asset purchases—bond buying—that we’ve come to know (and love/loathe) as quantitative easing, or QE.
As close observers know, this is the third round of quantitative easing, which is why we called it QE3. And the very fact that it took three iterations of such a seemingly radical policy—creating “money” out of thin air and using it to buy financial assets—has prompted some to argue that it couldn’t have been that effective. (Short version: Nobody really knows. It’s true, however, that the US and UK economies, which both undertook QE in the aftermath of the Great Recession, are doing much better than the euro zone, where the ECB didn’t.)
Skeptics would stress that the most difficult trick for the Federal Reserve to pull off still lies ahead. That will be ensuring that it can actually raise interest rates when the central bank determines that inflation is getting out of control. (The Fed says it can, thanks to some new tools it has.)
I don’t think that’s right. The real challenge the Fed will have to deal with is likely a drumbeat of calls for it to “get back to normal” sometime soon by raising interest rates.
Let’s be clear. There’s absolutely no reason to do that now. Key measures of inflation show very little increase in the rate of price increases. In fact, the Fed’s preferred gauge of inflation, the core PCE price index, has consistently undershot the bank’s own goals. And with the strength of the US dollar driving global oil prices lower, the risk is that prices grow slower and slower.
And while the job market has improved a lot, there are still plenty of people who need to be brought back into employment. For instance, take a look at the US employment-to-population ratio for prime working-age Americans. While it is improving, it still suggests that there is more healing to be done.
Moreover, there’s a rich history of governments rushing too quickly toward hard money and re-submerging their economies in the process. Whether it was Britain going back on the gold standard in 1925, the US in 1937, or Japan’s tax hike in the late 1990s, the tendency seems to be to move too fast, rather than too slowly. In fact, after Sweden’s Riksbank felt good enough to hike interest rates back in 2010, it now finds itself confronting the so-called zero-bound.
A similar situation for the Fed would be an outright disaster. It would be as if the totemic former Fed chairman Paul Volcker had, after breaking the back of inflation with his brutal interest rate hikes in the early 1980s, then allowed inflation to spiral out of control. It would have destroyed the credibility of the institution.
What’s more, such a policy failure would make it even harder for the Fed to win its next fight with inflation—or deflation—as the markets would become even more skeptical that the Federal Reserve has the gumption it needs to see things though to the bitter end.
Make no mistake, there’s a bit of alchemy to central banking. If the Fed allows a several-years’-long effort to restart growth to be short-circuited by too hasty an increase in interest rates, some of its magic would be gone forever.