What the FED Should Do Now. by Michael S. Rozeff

The last time I "advised" the FED on what to do was on Feb. 6, 2012. I "told" Ben not to do QE3, and he didn’t. Instead, he did Operation Twist. This was the second one of its type. The first Operation Twist occurred in 1961. The Twist is an attempt by the FED to alter the shape of the bond yield curve. It really doesn’t succeed. Considering the huge size of the debt market and the arbitrage that occurs along the spectrum of bonds of different maturities, it’s hardly to be expected that the FED is even capable of altering the yield curve in any economically significant manner. Most of the FOMC and its staff knew it would be futile (or should have known), because the research on the effect of the 1961 operation concluded that it did very little and accomplished nothing. This didn’t stop them in 2012. Why do something so futile? My guess is they wanted to throw some kind of a bone to those who were urging the FED to do more, including some on the FOMC itself. They had little to lose and something to gain, which was to buy time and give the appearance of acting.

In order to make any kind of a respectable intellectual case for Operations Twist of 2012, they had to have invoked Modigliani and Sutch’s work that claimed that the bond market was segmented due to various legal and institutional restrictions. The "preferred habitat" theory of the latter says that bond investors are so accustomed to dealing in their preferred maturity ranges that they won’t move outside them to take advantage of interest rate differentials. It’s an unappealing theory that requires people to overlook easy profits. An empirical paper written by Phillips and Pippenger (published in 1976) rejects the preferred habit theory; Pippenger was visiting at the St. Louis Fed at the time. A paper by Eric T. Swanson of the San Francisco Fed estimates the effect of the latest Operation Twist to have been only 15 basis points. We can conclude that Operation Twist again was futile.

So much for that. The months went by. The monetary base stabilized. I was reasonably pleased that the FED had stopped monkeying around with the markets. That was up until recently when a new push to do another QE or, failing that, to do "something" emerged. I felt that the best thing that could happen both for the financial markets and the economy, short of the essential radical and ameliorative measures that seem as distant as ever from the minds of policy makers, was no new shocks emanating from the central bank and the government. Patience, patience, patience. Calmness, calmness, calmness. Let the economy recover naturally. Let uncertainties dissipate. Stop being overly fixated on every twinge in every economic indicator. Stop interfering and stop yapping about every new number that comes out. If the numbers could all be turned off before they reach the ears and desks of policy makers, that would be even better. It would deprive them of the catalyst that gets their control mentality going.

Meanwhile, because of the FED’s bloated balance sheet and the difficulty they will face reducing it ("exiting") if ever they do, I felt that, if anything, they should take some steps in that direction now. Why not let some air out of the bubble now by starting to alter the view that the Bernanke put option is an ever-present reality? This (exiting) of course would create huge commentary and even angst. In what quarters? Some in Congress, but even moreso in the angst-ridden financial press, which, I have to say, seems to cheer on the FED’s every action to do more, and more, and more. This press (old, new, internet, blog, tv, radio and whatever) is a hall of mirrors in which most everyone seems to speak up for the "markets" and everyone else, claiming that they are demanding more QE, and unless it happens, the world will fall. Then there are the spokesmen for various investment outfits that want prices to rise. All these voices blend into a self-fulfilling prophecy. Although the FOMC is to some extent "above" these demands, I get the feeling that the members are not nearly enough above it and insulated from it. They read commentaries on markets and the economy and, being mortal, they are influenced by them.

But if the FED intends to do more QE, what can it possibly accomplish? What did the FED’s earlier moves do and not do, by whatever names one may wish to call them, like quantitative easing, credit easing, or interest-rate targeting?

QE is a policy of buying bonds, usually government bonds, in order to increase bank reserves. A policy of credit easing that involves buying the bonds of some entity like Fannie Mae also increases bank reserves, and the same goes for making a target interest rate lower. Inflation by any other name is still inflation. Along with QE, the FED now pays interest on bank reserves, so that it can sterilize or neutralize the effect of a big buildup in bank reserves by paying enough interest that the banks keep the reserves on deposit at the FED and do not lend them to each other. The neutralization allows the FED to target credit to a favored sector like mortgages, while stopping up the money creation side, if it so wills.

The effects of QE depend on the level of interest rates. Bringing rates down from 6 percent to 3 percent via QE has more of an effect than when rates are 0 percent, start and finish, and the FED does an asset purchase. They also depend on the condition of the financial markets, what the government is doing, on the state of the economy, on various expectations, and on bank regulatory policies. And they also now depend on the interest rate that the FED pays on bank reserves.

In the pre-2008 situation, monetary matters were usually much more simple to understand brcause the FED was moving rates up and down while they were well away from the zero mark. From 1945 to 2008, the FED often eased or bought bonds (inflated). This was de facto QE, although the name came only in the last few years. The banks then became flush. They increased their mortgage, consumer and business loans. The housing sector responded. Building quickened. Auto sales rose. Inflation in prices rose after awhile. The FED helped the big banks by simultaneously stimulating the economy, but if the economy became too frothy and price inflation too high, it had to slow it down. So, conversely, the FED at times tightened (deflated) and the economy slowed down or went into recession.

When a war occurred, the situation altered somewhat. Price inflation would go up more quickly and sharply. The FED would accommodate the government’s borrowing. There were also trends in operation as these irregular ups and downs occurred, namely, the FED kept inflating and government kept growing and so did its debt, all on a long-term secular basis. These secular trends accelerated when the currency was divorced entirely from gold in 1971. The long-term QE was hardly benign, any more than its cyclical aspects were benign in producing booms and busts.

QE was bad prior to 2008 because of its secular effect of aiding and abetting big government, big government debt, big wars, and a big welfare state; and also bad because of its production of business cycles.

But QE does not have the same effects at all times. When the economy has a very big recession such that the short-term interest rate gets near zero, the impact of QE changes. It goes down. This happened in the 1930s. The monetary base built up substantially in the 1930s, but unless banks turned around and loaned out their excess reserves, the QE could not have much effect. Their lending, in turn, depended on the kinds of factors I mentioned above, which include government actions, the state of the economy, expectations, and regulations on banks. The same goes for now, with an added factor that the FED pays interest on reserves. QE may now be ineffective in stimulating economic growth, but now it’s bad for other reasons.

People and businesses do not have to borrow when banks are flush with reserves. This creates slippage between a FED QE action that alters reserves and its impact on the economy via bank lending. The slippage is due to all these intervening variables that influence people’s behavior. The FED is really operating very much in the dark. It can press down on its gas pedal but it doesn’t know how the automobile will respond or even if it is responding. The FED gets data about the economy but it doesn’t know what effect its stepping on the gas pedal may have had. It continually does research and so do speculators and academics, but no one knows for sure what the causes and effects are. What should actually be done in this situation is to end the FED and allow the market to produce money and credit, but that is another story.

When the FED became very active in 2008, its goal was to provide credit to member banks. The banks ordinarily shifted bank reserves and short-term loans among themselves, but the lending banks stopped lending when it became clear that the borrowing banks might be insolvent because they held bad loans. The whole levered fractional-reserve system seemed poised to collapse. Actually, it wouldn’t have. The larger mis-managed and risk-prone banks may have failed, but they could have been broken up. The better managed and solvent banks would have picked up some of the pieces by buying loans of the bankrupt banks at their market values. This restructuring was not allowed to happen, because the big banks wouldn’t have it. Instead, the FED kept the whole system going by making loans to banks. To these loans, it layered on QE1, which flooded the system with reserves.

The banks that were overextended and borrowing reserves were the larger banks, including those in New York, while the lending banks were in the hinterland (except for the upstart large regionals that become big). So that, exactly as Gary North says, the FED acted as the tool of the big banks. The QE that it did was not directed at big banks via the economy as in earlier decades. It was aimed directly at the big banks and their balance sheets. It succeeded at the goal of saving them, at least so far, and various intermarket spreads declined in size. Some of these banks are still limping along, however.

With short-term interest rates near zero and long-term rates having fallen, the excess reserves of the banks pile up at the FED, which is paying interest on them. (Actually this indirectly comes out of the pockets of taxpayers.) The stimulative effect on the economy becomes nil in the sense that it is not stimulated by more and more reserves piling up. The FED has gotten sellers of some long-term bonds and MBS to sell them to the FED in exchange for short-term debt (cash and reserves). They hold them because interest rates are low. Banks may be willing to make loans, but there must be willing borrowers. Without borrowers, there is no stimulus from QE. But as long as QE persists and asset values in some markets are based on it, businesses are uncertain of long term values. They don’t know when or if the FED will exit and what will happen to prices when they do. The uncertainty adds to all the other factors currently inhibiting business.

I digress for one paragraph to say that there is altogether too much stress placed upon credit as an engine of an economy. In an economy that lacks credit facilities and financial intermediaries, developing them is very important. But in a developed economy that already has such intermediaries and knows how to create more if some of them fail, credit is the tail, not the dog. Credit is finance, and finance is far less important in a developed system than is real investment. A business places prime emphasis on its asset side: its products, its costs, its competition, and its revenues. Financing is distinctly secondary. From this perspective, way too much attention is given to the FED as an economic force and the FED itself thinks of itself as far more significant than it is on the real economy. By doing so and by catering to the more risk-prone banks, what it succeeds in doing is nurturing speculative booms and then the resulting busts.

The QE programs may be doing little or nothing when interest rates are very low, but they still have the effect of shunting aside serious reform of the money and banking system. They keep in place the big banks and their managements. The large bonuses keep rolling in. A flawed system remains in place.

Relieving the big banks and/or financial markets from possible bankruptcy is not the same as creating real investments, business investment, liquidating malinvestments, moving labor into new occupations, creating new jobs and economic growth. Does QE accomplish these goals? Let’s see.

Japan did QE well before the FED did. In 2002, a team of the Bank of Japan’s economists studied its impact. This is a complex paper that has models and estimates of the effects of QE in Japan. There are several cases that they analyze, and they conclude

"Overall, these results suggest that the effectiveness of the monetary base channel is very uncertain, and we cannot find any certain route through which the central bank can provide stimulus to the economy at zero interest rates.
"In sum, the results of this section suggest that the effectiveness, if any, of the monetary base channel is highly uncertain and very small. We cannot find any certain route through which the central bank can provide stimulus to the economy at zero interest rates."

At the zero bound of interest rates, the effects of the monetary base expansion are "highly uncertain and very small." If you’d like to read a much simpler discussion that yet produces the same kind of figures, then see Hussman. For a straightforward debunking that QE has any stimulative economic impact at all, see Roche. For a paper with findings similar to that of the Bank of Japan, there is a Federal Reserve study with these conclusions:

"This suggests some scope for quantitative easing to affect the supply of credit, particularly during periods of financial stress. However, the overall effect was measured to be quite small, so that eye-popping amounts of liquidity would have been needed to achieve noticeable effects."

For a detailed verbal (readable) evaluation of the QE program of the Bank of England, see Colin Ellis. He concludes

"All told, there are few signs that the BoE’s asset purchase programme has had much impact on the real economy to date. Financial markets have improved – but that appears to have largely reflected global developments, rather than the Bank’s purchases."

The literature to date is uniform in its appraisal that QE doesn’t stimulate an economy when interest rates are near zero or very low. Such an economy can recover naturally, of course, if given time.

After awhile, studies will appear about the effects of QE1 and QE2 on the American economy. We have already heard Janet Yellen (who is the Vice Chair of the Board of Governors of the Federal Reserve System) claim that QE1 and QE2 created 1.8 million jobs through 2011 and will create 1.2 million more in 2012. She essentially attributes all the job growth in the economy to the FED’s asset purchases. Given what we know about Japan and the United Kingdom, what she claims is ridiculous. I view Yellen as wholly untrustworthy and a rampant inflationist. For an example of her views, see here.

What should the FED do now (beside going into Chapter 13 bankruptcy)? It should do no harm. Sadly, this is actually asking a lot! There are too many activist and impatient Keynesians in the FED.

The FED should not lower the interest rate on bank reserves in order to stimulate lending. That will have an horrendous signaling effect on markets, leading to higher bubble prices. We do not need more bubbles. It should not start up another QE program. This will be useless and could likewise unleash a run against the dollar.

It would be nice if the FED would ask Congress to remove its dual mandate and replace it with a single mandate of price stability. Otherwise, an unbelievable crew of naive FED inflationists who are in positions of FED power, Keynesians all, is anxious to turn the FED into an inflation engine beyond anything ever before imposed on the American people, Revolutionary War finance excepted. These dangerous central bankers need to be stopped before they come up with some new harebrained scheme.

Bernanke wrote a letter to a Congressman that surfaced the other day and he wrote "there is scope for the Federal Reserve to ease market conditions." This can be interpreted in a dozen different ways. Maybe the latest released minutes of the FOMC have a clue or two. We learn that

"Participants also exchanged views on the likely benefits and costs of a new large-scale asset purchase program. Many participants expected that such a program could provide additional support for the economic recovery both by putting downward pressure on longer-term interest rates and by contributing to easier financial conditions more broadly."

A bunch of people in the room view QE as effective and think QE3 will stimulate the economy. Don’t they read the research that has been done?

There is then a passage expressing the concerns that other participants had about a new QE program, such as its low efficacy, its transitory effects, its effect on the balance sheet making it even more difficult to normalize it, and that such a QE "program could increase the risks to financial stability or lead to a rise in longer-term inflation expectations". This group makes more sense to me and is, I believe, more in line with both reality and reasonable analysis.

And that is followed by a comeback by the "many" inflationists who propose that if the program is kept flexible, to be adjusted "in response to economic developments or to changes in the Committee’s assessment of the efficacy and costs of the program," this answers to the objections and reservations of others.

Overall, the FOMC discussion’s give and take reveals that it is flying blind. As a group, they literally do not know what they are doing. They don’t know the effects of their actions. This is seat of the pants monetary manipulation, and they don’t suffer if things go wrong. They just move back into academia or a consulting job. The discussion reveals the weaknesses of a centralized committee approach to managing a nation’s money supply and allowing a bunch of economists to make decisions, who cannot agree with one another, who don’t know what’s going on, and who do not face sanctions when they blunder.

The inflationists are entirely ad hoc in their approach. That is part of what being "flexible" means in this context. To them, they are playing a chess game with the economy. They will wait and see what moves their opponents make and then react. They have no real plan, unless it be "inflate and see". The other part of such a flexibility is that it becomes a ticket for open-ended inflation at the discretion of the FOMC.

End the taxation of transactions in gold and silver. End the legal tender status of the Federal Reserve’s dollar. End the laws that prevent private coinage. Divide banks into those that provide 100% depositories for money and those that do not. End the FED’s privileges. Separate the FED from the government. Allow banks to offer silver and gold accounts. Distribute the gold stock to Americans.