A few days ago Ben Bernanke, chairman of the Federal Reserve, was asked to identify the biggest obstacle to economic recovery. That “we don’t have the political will,” he replied.
Mr. Bernanke showed his own will on Wednesday March 18th, when the Fed’s policy panel said it would purchase $300 billion in Treasury debt, mostly maturing in two to ten years, starting next week. It will also boost its purchases of mortgage-backed securities to a total of $1.25 trillion from a previously announced $500 billion, and its purchases of debt issued by Fannie Mae and Freddie Mac, the mortgage agencies, to a total of $200 billion from $100 billion.
The Fed had already said it was considering Treasury purchases, but expectations had waned in recent weeks. The announcement electrified investors, sending the Dow Jones Industrial Average up by 91 points, or 1.2 percent, and the ten-year Treasury bond yield down a stunning 50 basis points to 2.51 percent.
The plans are awe inspiring in their scale, but they are different only in degree rather than kind from the steps the Fed has already taken. In December, it exhausted its supply of conventional monetary ammunition when it lowered its short term-interest rate to between zero and 0.25 percent. At that time it had already started unconventional operations: expanding loans to banks and other financial institutions; buying private commercial paper; making enormous and controversial loans and loan guarantees to AIG, Bear Stearns, Citigroup and Bank of America; and setting up a facility, capitalised by the Treasury, to buy securities backed by car, student and small-business loans, and mortgages. By the time its new steps are done, the Fed’s balance sheet will reach $4.5 trillion, or about a third of GDP, up from less than $1 trillion a year ago, Capital Economics estimates.
All these steps were aimed at reducing credit spreads on private loans and increasing the supply of private credit, currently constrained by fear of counterparty default, illiquidity and banks’ depleted capital. They have worked to some extent, as spreads on private debt have come down, though they remain well above pre-crisis levels.
Taking the added step of buying Treasuries made some inside the Fed uncomfortable. It amounts to monetising government debt — in essence, allowing the government to finance its spending with newly printed money rather than by borrowing or through higher taxes. That raises two fears: that it would eventually lead to inflation, or even hyperinflation, and that it would compromise the Fed’s independence.
The fear of inflation is exaggerated. Inflation was just 0.2 percent year-on-year in February, the government said on Wednesday. While core inflation, which strips out food and energy, was a more normal 1.8 percent, that is probably headed lower as high unemployment and unused capacity put downward pressure on wages and prices. The Fed repeated in its announcement that it “sees some risk that inflation could persist for a time below [its preferred rate].”
As for the Fed’s independence, Mr. Bernanke has previously argued that should be more of a consideration in times of inflation, rather than deflation. In any case, the Federal Open Market Committee, which approved the decision unanimously, appears to agree such risks were an acceptable price for more forceful action against the recession.
Following a similar announcement by the Bank of England, the Fed’s action understandably suggests central banks, having approached the limits of conventional monetary easing, are now experimenting with more monetarist solutions. And the monetary base (currency plus commercial bank reserves) has grown sharply in America, Britain and the euro zone. The Bank of England describes its actions in monetary terms: by expanding the amount of money in the hands of the public, some people will shift to riskier assets such as stocks and bonds, raising wealth and spurring investment. Banks may use the reserves to make higher-returning loans.
But an expanding monetary base will not create inflation if the money is not lent out. The Bank of Japan engaged in quantitative easing earlier this decade, buying government debt and raising commercial bank reserves. Banks did not expand their loans because their capital was constrained and loan demand was weak.
The Fed has explicitly described its goals as lowering the cost and improving the supply of private-sector credit; that this results in an expanded monetary base is secondary. Even Treasury purchases are meant to “improve conditions in private credit markets.”
In the short term at least, the Fed’s actions raise the odds that the economy, in recession since the end of 2007, will pull out by the end of this year. There have been signs the housing market has stabilised, albeit at deeply depressed levels, and lower mortgage rates will bolster demand. If share and home prices stabilise, that will mitigate the astonishing loss of wealth that is depressing consumer spending.
But the Fed cannot do the job by itself. For one thing, many borrowers are unable to take advantage of lower mortgage rates because of stiffer underwriting requirements. Many corporations are either unable to borrow because lenders are more skittish or unwilling to borrow because the business outlook is so weak. Barack Obama’s administration has tackled the first problem with plans to help homeowners refinance and avoid foreclosure. It is to announce within days how it will remove toxic assets from bank balance sheets and regulatory tests should soon disclose how much more capital the government must inject into the banks.
The problem is that the administration’s ability to get the extra funds needed for these schemes has been significantly injured by the outrage among voters and Congress over bonuses paid to recipients of bail-out money. That thirst for retribution could also deter banks, investors and others from participating in the schemes. “I don’t want to quell anger, what I want us to do…is channel our anger in a constructive way,” Mr. Obama said on Wednesday. That will take political will from him and Congress. For now, Mr. Bernanke has done his part.