The Fed’s great economic experiment
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The Fed is operating in no-one’s-ever-really-done-this-before territory. Since the financial crisis, the Fed’s balance sheet has tripled and key interest rates have been effectively at zero for nearly three years, in what economist William White refers to as “one of the greatest economic experiments in history”.
As in all experiments, unexpected stuff happens. White’s new paper, “Ultra Easy Monetary Policy and The Law of Unintended Consequences”, amplifies what Bill Gross and Mohamed-El-Erian have been harping about for months.
White’s clear that the Fed’s various actions helped lift us out of the financial crisis. But this amounts to buying time, White says. The Fed’s low rate policy in medium term has all sorts of nasty unintended consequences, including:
They create malinvestments in the real economy, threaten the health of financial institutions and the functioning of financial markets, constrain the “independent” pursuit of price stability by central banks, encourage governments to refrain from confronting sovereign debt problems in a timely way, and redistribute income and wealth in a highly regressive fashion. While each medium term effect on its own might be questioned, considered all together they support strongly the proposition that aggressive monetary easing in economic downturns is not “a free lunch”.
White casts doubt on whether low rates can generate a lasting wealth effect by juicing the stock and housing markets:
Lower interest rates cannot generate “wealth”, if an increase in wealth is appropriately defined as the capacity to have a higher future standard of living. From this perspective, higher equity prices constitute wealth only if based on higher expected productivity and higher future earnings…As for higher house prices raising future living standards, the argument ignores the higher future cost of living in a house. Rather, what higher house prices do produce is more collateral against which loans can be taken out to sustain spending. In this case, however, the loan must be repaid at the cost of future consumption. No “wealth” has in fact been created. In any event, as noted above, house prices in many countries have continued to fall despite lower policy rates. This implies that the need for “payback” can no longer be avoided by still further borrowing.
Izabella Kaminska also helpfully points to White’s questions about the limits of the Fed’s credibility. To boost the economy, the Fed could raise its inflation expectations — something Fed critics like Ryan Avent have been calling for. But, after multiple rounds of QE, years of high unemployment and lower-than-expected-inflation, will anyone actually still have faith in the Fed?
The Fed could also push interest rates into negative territory, which theoretically would push companies to spend their growing cash hoards. In this scenario, instead of paying you an interest rate, a bank would charge you to hold onto your money. A new post at the NY Fed says negative rates could lead to an “epochal outburst of socially unproductive — even if individually beneficial — financial innovation” (Think of consumers holding onto checks for months to avoid paying their banks to hold their money. Cardiff Garcia also made an exhaustive argument against negative rates on excess bank reserves here).
And while savers certainly hate the Fed’s low rate regime, banks aren’t crazy about it either. Low rates mean that new lending, which the Fed has long tried to boost, has become less profitable, Stephen Gandel notes. — Ryan McCarthy
On to today’s links: