The Fed's last throw of the dice

by David Taylor

Let’s say we walk into a department store together and I see a big screen TV that I really like. It has everything you could ever want and would fit perfectly in my home. We check the price tag… it’s well outside my price range. Ah well, move on to something less expensive and actually within my budget. That makes sense, right? Not if you’re the US Federal Reserve. The Fed is the US equivalent of Australia’s Reserve Bank. It even has a pretty similar mandate to the RBA – maintain price stability and work towards achieving full employment in the economy. The Federal Reserve has indicated by its most recent actions that the best way to solve this basic dilemma of not being able to buy what you want, is to print more money – just make it up from scratch!

OK so what exactly does the Federal Reserve want to buy that it can’t afford? The answer is a healthy economy. So I admit it’s a little more abstract than a TV but the comparison still holds. The Federal Reserve would really like a healthy economy, but at this point in time, it’s a little outside the bank’s price range.

Let’s imagine we could all print money though. Wouldn’t that be great?! I know what I’d like to buy. I’d go for a huge yacht with all the modern conveniences. Actually make it 5 huge yachts anchored all around the world. Oh and my own personal jet – to get to the yachts of course. The only problem with this is that if I found a way to legally print money, there’s every chance my neighbour would also want to do the same thing. This poses a big problem, because if everyone starts to print their own money, the people selling the products and services we want to buy will start to put up their prices. They’d do that because it would be an easy way to increase their profits. They’d also have to do it because their stocks would run out otherwise – and why not raise your prices as much as you can while you can – before stocks run out. There’s some economic theory behind this (demand and supply forces) but that’s the basic idea. At the heart of all this is that if I had an unlimited amount of money to spend, the system would eventually catch up with me. Prices would rise so high that I’d eventually need to carry a wheelbarrow full of money with me down to the store in order to buy a loaf of bread. Money would lose its credibility, its value.
The Federal Reserve doesn’t want to buy a yacht, or a loaf of bread for that matter, it wants a growing, functioning economy. More specifically, it wants to create jobs – lots of them! - Hundreds of thousands of them every month. But it’s using the idea above to achieve that end.

So will it work?

At the moment the US unemployment rate is sitting at a little over 8 per cent. That means, roughly speaking, there are as money people unemployed in America as the entire population of Australia. The odds aren’t looking good.

Well then what specifically is its strategy?

The Federal Reserve said in a statement just a few days ago that its solution is to print more money. The policy is known as quantitative easing. That’s a euphemism. It means the Fed will buy mortgage-backed securities from the commercial banks, and, in exchange, give the banks cash (fresh off the printing presses). It’s free funding for the banks, and by the Fed buying up mortgage securities, it creates demand for these longer-dated debt securities, pushing up the price, and bringing down longer term interest rates.

An even simpler way of looking at it though is that it gives the banks money to play with – money to lend out. The banks would normally have to pay for this money (borrowing it at 5 per cent, then lending it out at 7 per cent). This way the banks can lend it out at a huge discount because it didn’t cost them anything to buy in the first place. It also puts potentially risky mortgage-backed securities off the banks’ balance sheets and onto the Fed’s balance sheet. Pretty neat, right? Sure, but we live in extra-ordinary economic times and this unconventional monetary policy solution lacks a bit of punch in the current climate. There are two reasons for that: First, because the Federal Reserve is attempting this for a third time having been unsuccessful with the policy before; but second, and of absolutely crucial importance, the demand for those loans the banks are trying to make super cheap, is simply not there.

This gets right to the heart of the economic dilemma for the United States. Consumption is a large proportion of what economists call GDP or Gross Domestic Product. It’s the total income or output for the economy. It’s widely understood that the US consumer drives the world’s biggest economy. Right now though, the consumer isn’t so keen to buy stuff - whether that’s a house, a car, or some other big ticket item. They’re still saving and somewhat shell-shocked from the global financial crisis. Another problem is that many consumers simply don’t have a job, or a worried they’ll lose their job tomorrow. It doesn’t really matter how much the banks can discount their loans, the demand isn’t there.

What is truly astonishing this time around though is that the Federal Reserve seems to have become quite stubborn. It announced last week it’ll now buy $40 billion worth of agency mortgage-backed securities from the banks each month. That’s on top of what it’s already committed to. As it stands, the Federal Reserve is now pumping around $85 billion into the US banking system (the economy) every month. The Fed said it’ll continue to print money and pump it into the economy until the unemployment rate starts to come down. It’s like a petulant child that wants a lolly and is stamping its feet until its parents cave in.

So what about what you were saying before about prices rising too much, is that the bank’s biggest problem? Is that why being stubborn will land the Fed in hot water?

The concern about rising prices (or inflation) is not there right now. There’s not enough demand in the economy for that to be a near term threat. But it also means the policy itself lacks obvious potency. Ideally the bank would print enough money for the economic wheels to start turning again and then cut it off just before prices start to rise too high. But it doesn’t look like the policy will gain much traction to begin with.

This isn’t all the banks own fault though. Part of the problem is that the US congress has become fiscally ineffective. Republicans and Democrats can’t agree on the mixture of tax and government spending policies and have effectively diluted the role of fiscal policy. It’s put an enormous, and inappropriate, burden on the central bank’s ability to get the economy going again.

So where to from here?

Well this type of policy stance, regardless of what the Fed says, can’t last. It’s been manufactured with enough time before the US Presidential election that if it works to bring the unemployment rate down just a little (below 8 per cent), it’ll be regarded as a success (even though it will have done very little) and Obama will likely turn off the money taps after he’s elected. If it’s a failure, Mitt Romney will likely use it as an excuse to sack the Fed’s President, Ben Bernanke, and start again.

We live in extra-ordinary economic times that have led to extreme central bank policy responses. It means whatever the ultimate outcome, there’s every chance it’ll be an unprecedented one.

David Taylor

Disclaimer

The content in my blog is non advisory, please do not interpret this as advice in any way shape or form. These are just my thoughts and nothing I say should be acted upon.