The Fed -- One-Armed Juggler with Hand Grenades

As many of you know I am a retired professor. That means prunes for lunch followed by a well-deserved nap. Recently I was invited to a lecture at my local university and in a fit of insanity I decided to encounter traffic, parking, and students-walking-with-phones. I am happy to report that I made it to the lecture and back home without incident.

I won’t go into the details but it was a very prestigious group of speakers with prominent alumni in the audience and many of the grad students wearing their finest coveralls. Some of the speakers represented the past and present of the Fed.  

I am both glad and sorry that I attended. I am sorry because I am not used to sitting so long in regular (not sweat) pants with a belt. I am also not used to other speakers going on and on and on. It isn’t so bad when I excite my audience with thirty minute explanations about totally obvious points – but when I am at the receiving end it is quite another matter.  But I am not sorry I went because I learned a lot from these speakers. 

They spoke about the onset of the last recession, about policies aimed at the recession, and they ended by speaking about the future.  Much of what they said I agreed with. But some of what they said really alarmed me.

Agreement – in the face of the worst financial and global economic crisis since the Great Depression, the government and the Fed needed to provide some quick liquidity and some stimulus. I am not one of those economists who believe that in 2008 Adam Smith’s so-called Invisible Hand was the best approach. The Fed should have played the role of lender of last resort. The government should have applied some stimulus. But once we agree on that then we start to take different paths.

This is not the place to enumerate all the differences. Instead I want to focus on a couple of threads that really scared me. The first has to do with the assessment of the Fed’s use of quantitative easing or QE. One panel member said that when interest rates get to zero, then QE is necessary. So it was perfectly okay and successful for the Fed to begin actively buying mortgage-backed securities and long-term government bonds. The reason this was okay and successful was evidenced, according to this speaker, by stabilizing inflation expectations.

Note: These speakers said a lot of things and I have to admit that I was dozing now and then. So it is perfectly okay for the reader to interpret my remarks as targeting some unspecified speaker if I have not faithfully represented  views actually espoused that fine day.

One could say that since inflation is the key objective of the Fed, it goes without saying that a policy to address inflationary expectations was well in the purview of the Fed. Since demand and inflation were falling at the onset of the recession, it seems the Fed did the right thing with QE. But that would be too simple for several reasons. First, with its usual tools, the Fed’s mandate has always been macroeconomic. The Fed is not supposed to bailout a tornado-damaged community or help a beleaguered furniture industry. It had a dual mandate to approach national goals for inflation and unemployment. Buying short-term government bonds so as to influence the federal funds rate was compatible with stabilizing the economy. But buying mortgage bonds and long-term government bonds is a horse of a different color.

Second, buying mortgage bonds is basically what it is – helping out the mortgage market and the housing industry. You might argue that if the mortgage market was the source of national problems then it made sense to buy mortgages. But that’s a sticky wicket since QE started well after the beginning of the recession and continues today. Many would say that this practice of focusing on a particular industry is simply inappropriate because it is really fiscal policy. I would also say that it has already become ingrained in Fed policy and thinking. Somehow the Fed has gone from monetary policy to fiscal policy. Since the government is supposed to be the one doing fiscal policy is just doesn’t make sense. The Fed has neither the appropriate tools nor the jurisdiction to have permanently changed its modus operandi. Remember what the Fed does is determined by national law. As far as I know the law didn’t change.

Third, buying long-term government bonds is also another change and a ruse at that. It is no secret that government stimulus programs dramatically increased the need for the government to borrow. Having the Fed in these markets creating a huge demand has certainly made it much easier for the government to borrow – and keep borrowing long after the storm has passed. Was this QE done to stabilize inflation or to support government borrowing? If it was the latter then in just a few years this Fed has thrown away both its independence and credibility.

The second worry is that the Fed has no real plan to stop QE. Sure it has been slowing purchases for a few months but there is still no clear evidence it will stick to this path when Chair Yellen regurgitates Bernanke’s promise to keep interest rates at near zero until the economy is clearly strong enough. But is the road to Hell not paved with good intentions? Every time the economy reaches another milestone the Fed smiles and tapers, and then the markets react badly. Good news is bad news? Postponing the tapering then leads to market jubilation. Is Janet Yellen really going to remove the punch bowl? If markets bless less tapering – the Fed takes this as a sign of policy success. When the market hisses at more tapering, surely the Fed will cave to the markets drug addiction for Fed asset buying.

The Fed put itself and us between a rock and a hard place by promising low interest rates when every indicator is that rates will and should rise to more normal levels. If the Fed does the right thing and returns to a normal policy, rates will likely overshoot and create another recession. The government will accuse the Fed of terrible acts since it will have to borrow at higher rates. Housing market participants will cry even louder.  If the Fed does the wrong thing QE will feed bubbles in housing, government bonds, and stock markets, facilitate the spending and debt appetite of the government, raise inflation expectations, raise interest rates, and likely cause a quick growth spurt followed by a recession.

There are good reasons why the Fed had a simple mandate. A one-armed juggler can only keep so many balls in the air. This Fed has too many balls in the air and they will soon be landing on our heads. No more seminars for me!