Fed Risks Undercutting QE's Impact

Most central bankers are preternaturally concerned about inflation. This trait, whether a product of nature or of nurture, makes them good custodians of the longer-term value of their currency, but bad dinner companions. At this juncture, US Federal Reserve officials have much less reason to be preoccupied with inflation than is their wont.

Core inflation, or the total stripped of food and energy, is running at less than 1 per cent, or one-half of the Fed's goal. Meanwhile, resource slack, which puts downward pressure on inflation going forward, is likely to shrink only slowly. This may appear disappointing compared with the typical recovery since the second world war, but par for the course historically after a crisis. After all, the pre-crisis spending spree was fuelled by leverage and it takes several years of sluggish spending in relation to income to pare debt loads.

Thus, Fed officials have reason to seek to make monetary policy more accommodative. With its nominal policy rate already at zero, expanding the balance sheet by purchasing assets with newly created reserves, quantitative easing (QE), is the obvious tool. The Fed's asset of choice is Treasury securities, the safest of them all.

Banks might be inclined to make use of some of those reserves by lending more. Investors might roll over the proceeds of their sales of Treasury securities to the Fed into riskier assets, such as mortgage-backed securities, corporate bonds and equities. Gains in those asset prices should raise wealth and encourage spending to work down slack. True, banks already are stuffed with reserves so that any change in lending will be slight. Also, capital has returned to finance trading, and markets are linked more effectively than in 2008. So the Fed might be less successful in influencing asset markets with purchases today. But asset purchases push in a helpful direction, in part by underscoring a commitment to support activity.

QE has risks. On one side, the Fed's competence might be called into question should there be no apparent benefit from the latest round. On the other, QE might work too well in restarting inflation if the Fed is slow to remove its accommodation when resource slack dissipates. These risks could be mitigated if the Fed were rule-like in applying QE. If the change in its Treasury holdings were linked to its outlook, the public could understand that asset purchases would last only as long as necessary.

For now, the Fed seems dead-set on retaining discretion by relating that its asset purchases will be routinely reviewed rather than relying on a rule. This clouds its commitment, undercutting effectiveness.

Vincent Reinhart is a resident scholar at AEI.

 

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