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Barron’s: You must feel some vindication that the very policy you have been pushing for several years is now being embraced, after a fashion, by the Bank of Japan, the European Central Bank and, once again, the U.S.
Reinhart: It is too early to take credit until they actually do something meaningful, and it wouldn’t be in my nature to do so anyway. Central bankers realize that they must use their balance sheets, now that the short-term rates they control have effectively hit zero and the expansion in the developed world remains so sluggish. More monetary ammunition must be unleashed.
Barron’s: Quantitative easing has very little history in economics.
Reinhart: There was one other important case study, the 1930s, when short-term rates were about zero from 1932 onward. When [President Franklin D.] Roosevelt devalued gold it was an effective quantitative easing, because the amount of monetary assets the U.S. had suddenly went up, even as the interest rate didn’t change. That quantitative easing is seen as pretty effective.
Barron’s: What about the Japanese attempt early in the decade? It didn’t seem to get much traction even though it was massive.
Reinhart: And that is also why you don’t want to declare victory too soon as the Fed seems ready to act again, because it isn’t just about what you do, it is how you do it. It is just as important that the Fed has the proper commitment and executes the policy properly. The problem with the Japanese is they went about easing in a half-hearted way. When they brought their policy rate down to zero, Japanese officials termed the move an “abnormal” one. If you call something abnormal you are signaling to markets that the policy will only be short-lived. Even after they began to expand their balance sheet aggressively, the tentativeness of their conviction reduced the psychological impact of the policy.
Barron’s: We’ve already had one spasm of quantitative easing in the U.S. Was it executed well? What should we do differently this time?
Reinhart: Events were different in 2008 and 2009 than now, and that calls for a different mode of execution this time around. Last time markets were still very frayed. There was lots of uncertainty. Financial-market players were terrified. Risk capital was paralyzed. So the Fed had to step in and make large purchases and announce a big number at the beginning in order to achieve a pronounced effect on market rates. There was a compositional problem. They bought so many mortgage-backed securities that they probably impaired the functioning of that market. But QE1 [the first round of quantitative easing] did work in changing markets, lowering market yields and encouraging financial markets generally.
This time markets are in better shape. The Fed has to work with markets rather than set prices. That means the Fed must tie its actions more to the economic outlook than repairing the functioning of security markets.
Barron’s: What are the economic metrics that the Fed should say it is targeting?
Reinhart: Four times a year the FOMC participants do an economic forecast. These are published in the meeting minutes. So four times a year the Fed has something it can show market participants, and then gear its policy to whether the forecast is above or below its mandate with regard to price stability and adequate employment levels. The first thing the Fed should do is explain that its asset purchases will be linked to its mandate relative to the FOMC’s outlook. That sends a clear signal that any market participant can use to extrapolate how much the Federal Reserve will be purchasing. This rule-based commitment would reassure the market of Fed discipline.
The expectation of further quantitative easing is already being priced into the market even though it hasn’t taken place. We’ve had a 50- to 65-basis-point [0.5 to 0.65 of a percentage point] decline in yields along the Treasury term structure. When the Fed announces more quantitative easing, we might not see that much of a reaction in security prices.
Barron’s: Shouldn’t it boost other asset prices along with Treasuries?
Reinhart: There will be a spillover effect on other asset classes such mortgage securities, other asset-backed debt, corporate debt and even the stock market, lifting prices some. Quantitative easing will also help in other respects. When the Fed purchases Treasuries, that also puts downward pressure on the exchange value of the dollar, and upward pressure on commodity prices.
Barron’s: Is that a good thing or bad thing?
Reinhart: That depends on your outlook. Certainly you can’t expect the chairman of the Fed to go around making speeches saying ‘hooray, we are depreciating the currency.’ Yet dollar weakness is a good thing as long as it is limited, controlled and gradual. A currency decline helps exports become more competitive. Rising commodity prices and more expensive import prices help fight deflationary forces. Remember, the Fed has said inflation is below its mandated level at present.
A modest boost in inflation also lowers interest rates in real terms by narrowing the gap between nominal rates and underlying inflation. The lower real rates are, the more borrowing and economic activity one can expect. Just recognize how unique a position we are in right now. It isn’t often that Fed policy involves inducing inflation rather than fighting it. That’s why execution really matters. One has to be careful not to create too much inflation.
Barron’s: What must the Fed do? Just announce limited asset purchases at each meeting and make them contingent on the performance of, say, unemployment and inflation expectations?
Reinhart: Two aspects are really important. You have to announce how much you want to buy during each period between Fed meetings. I think $80 billion to $100 billion in securities purchases sounds about right. That’s about the pace operationally that the Fed can do.
Secondly, you want all purchases tied to the Fed outlook, which, of course, is a forward-looking measure. If you keep purchasing Treasuries until you get the current inflation rate to where you want it, then the Fed might inadvertently overshoot its target. There’s a lot of inertia to inflation once it gets stoked.
Barron’s: Quantitative easing has its share of critics. A lot of folks regard it as financial kryptonite, just another step by the U.S. on the path to Zimbabwe’s status.
Reinhart: There are several fears. The big one is that quantitative easing can be used to monetize government debt and effectively print money to cover huge budget deficits. That’s how many emerging-market economies have gone off the rails in the past and behaved very badly. Hyperinflation occurs when central banks lose their discipline and monetary policy gets into the hands of the politicians. Once you turn the printing presses on it’s hard to stop the process. And tamping down inflation afterwards is just as painful.
That’s why you want a commitment tying any quantitative easing to a forward-looking outlook. The Fed should say it is going to be purchasing securities as long as inflation in its outlook is below mandate. By doing so it is implicitly saying it will not only stop all purchases but actually sell bonds once inflation in the outlook exceeds its mandate.
Barron’s: So that outlook provides an exit strategy?
Reinhart: Right. Monetary policy is based on the views, many of them differing, of lots of people. If the Fed tries to figure out today how much in Treasury securities to buy in the next year to get the outlook it wants, you have got problems. The Fed could wind up being wrong in just a couple of weeks. Data could come out differently than the Fed expected, and it might regret its commitment to purchase a certain amount of Treasuries. Or it might feel the need to buy more. You don’t want to tie your hands by announcing a number upfront.
Second, if you look out a year and say it is going to take that long to provide enough lift to the economy, there will be bank presidents that will be troubled by the idea of having to vote on a resolution that says, say, let’s purchase another $1 trillion of securities. They would be much more comfortable agreeing to a resolution that says, we’ll purchase $100 billion per meeting. Then, if circumstances improve more quickly, the spigot can be turned off quicker.
Barron’s: Some critics of quantitative easing point to the fact that the Fed, at least in the last round, appeared to be pushing on a string. In other words, the money it ladled out into the banking system remained unlent, and returned to the Fed balance sheet as excess reserves.
Reinhart: Even those critics will have to admit that quantitative easing pushes the economy in the right direction when inflation is unacceptably low and unemployment too high. Should one sit on one’s hands instead, and not use all the tools at our disposal? That’s just not acceptable.
Critics also ignore the fact that under double-entry accounting, quantitative easing isn’t just about the creation of a liability on the Fed’s balance sheet. The Fed is also acquiring assets in the bonds it purchases, and by buying the bonds it diminishes their supply and thereby raises their prices. The downward pressure on Treasury prices as a result of quantitative easing favorably affects other asset markets and the economy as a whole, even without the excess reserves being lent out
Also, by putting more reserves into the banking system, it at least creates the incentive for banks to use those reserves. One regional Fed president recently observed that by creating excess reserves, the central bank is giving a license to banks to create money. The banks might not exploit that license in the near term. But the potential and the ability is there, which is almost as important for the future.
Barron’s: Good point. Thank you.
Vincent R. Reinhart is a resident scholar at AEI.
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