Wednesday, August 17, 2011

QE3: Risks Outweigh Rewards

Earlier today I outlined Why QE2 Failed to positively impact economic growth or employment. The principle reasons for the ineffectiveness of monetary policy are based on the theory of a liquidity trap. In general one would only expect a liquidity trap to occur when private sector debt is extremely high and interest rates are already at the lower bound. Numerous economists have supported this theory based on current economic data and used it to push for greater fiscal stimulus. Despite the blatant contradiction, several of these economists have recently been calling for the Fed to employ further monetary stimulus through QE3. Given the relatively widespread agreement on the ineffectiveness of QE2, I’m sufficiently perplexed by these requests.

Economists aren’t the only group pushing for QE3. This morning I came across the following post from Zero Hedge, QE3 ON: Goldman Lowers Global Government Bond Forecasts Following 2012 US GDP Cut To 2.1%, Repeats "QE3 Is Part Of Baseline Estimates". Goldman not only claims QE3 is coming, but that several hundred billion is already priced in to markets. Supporting an opposing view, Dallas Fed President Richard Fisher spoke today about Connecting the Dots: Texas Employment Growth; a Dissenting Vote; and the Ugly Truth. Fisher helps explain his recent dissenting opinion by stating:

I posit that nonmonetary factors, not monetary policy, are retarding the willingness and ability of job creators to put to work the liquidity that we have provided.”

Surprisingly, several economists from the group noted above have been quick to write off these comments as foolish. The contradiction is once again apparent since Fisher is basically agreeing with the principle of a liquidity trap and current ineffectiveness of monetary policy. In the midst of all this debate over the merits of QE3, a noteworthy topic lacking any mention is the risks involved. To objectively make a judgment in this debate, this topic should be breached.

From my perspective there are two significantly large risks the Fed accepts in further expansion of its balance sheet. Yes, the policy is likely to create temporary commodity inflation that depresses growth, but that’s been addressed previously . The primary risks in focus here are a reduced ability to manage short-term interest rates and potential insolvency. One might argue that loss of confidence in the Federal Reserve Bank represents a third major risk, however that outcome is probably not a cause, but result of the other risks.

The central means by which the Fed controls short-term interest rates is through adjusting the supply of reserves. This influences the federal funds rate, which dictates the rate banks pay to borrow reserves overnight in order to meet reserve requirements and maintain balances sufficient to cover payments. Normally the Fed has maintained a slight shortage of reserves and increased the amount as necessary to meet its target rate. Increases in reserves are supplied through purchase of Treasuries, otherwise known as open market operations. As previously stated, QE2 was effectively a large scale version of normal open market operations. Despite its appearance, QE has altered the normal policy mechanisms of the Fed by vastly increasing the supply of reserves well beyond bank requirements. The Fed initiated a policy of paying interest on reserves in order to generate demand for the surplus.

As long as loan demand remains low and the private sector continues reducing debt, the Fed’s sizable balance sheet is unlikely to create problems in maintaining low nominal interest rates. However, at some point in the future the private sector will almost certainly experience renewed desire for borrowing. A subsequent increase in base money will push up inflation rates. Hopefully having learned from past errors, the Fed will increase short-term rates to restrain loan growth from expanding too quickly. This moment is where the large balance sheet becomes a concern.

When the Fed chooses to raise rates in the future, its normal policy would involve restricting the supply of reserves. But given the current oversupply, the Fed will have to reverse nearly the entire expansion of its balance sheet to affect rates in this fashion. This process requires unloading an enormous amount of Treasuries back on to the open market. Assuming economic growth is rebounding at this time, the Fed may end up exchanging its Treasury holdings at prices well below (rates higher) those paid at purchase. Realizing these losses would quickly cut into the Fed’s minimal capital because the central bank, even more so than commercial banks, is highly leveraged. If the Fed’s solvency is called into question, a general lack of confidence could sweep through the entire banking system and cause a severe reduction in base money.

Hoping to avoid this scenario, instead of adjusting the supply of reserves, the Fed could raise the rate of interest paid on reserves. This policy allows the Fed to manage short-term interest rates and maintain its sizable balance sheet. Despite its seemingly simple resolution, this policy is not without consequences. Considering the current low interest rate environment, increasing the interest on reserves could create a scenario where the Fed is paying interest in excess of earnings on its holdings. In this situation, the Fed not only witnesses mark-to-market losses on its holdings but could also experience a slow drain on capital. If inflation picked up quickly, the Fed would face the daunting prospect of trying to stem growth through interest rate hikes that could impair its own solvency.

QE is being discussed, any further expansions of the Fed’s balance sheet will only exaggerate these risks for the central bank going forward.

Based upon an objective view of the merits for QE3, the potential long-term risks seem to drastically outweigh any marginal short-term benefits. Considering recent statements by Fed members, it appears many are coming to a similar conclusion. Although I understand the desire for action during troubling times, policy makers should step back and assess the entire situation. The recent economic malaise has been most accurately forecast by theories including the concept of a liquidity trap. A scary but natural extension of this view includes accepting that monetary policy has been rendered ineffective for the time being. At this moment, nonmonetary policies are the best and only remaining hope for avoiding prolonged economic stagnation.

(Note: For those interested in a more extensive explanation of Open Market Operations, the
New York Fed website is a wonderful resource: Open Market Operations)

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