The Impasse of Monetary Policy - Part 5 - the impasse

Why The Fed, by itself, cannot deliver a sustainable recovery?

Part 5 -    The Impasse

 

3.0   THE IMPASSE

 

3.1   The nature of the problem

 Now that QE3 is concluded at the end of October 2014, the Fed now finds itself in one of the least desirable situations in its history because of: 

a)    An oversized balance sheet precluding further large bond purchases anytime soon;

b)     Interest rates sitting at unprecedented lows with not much room for further easing;

c)     Inflated financial asset prices whose contraction threatens any hope of stability;

d)     The US$ rising against other currencies fueling the risk of even larger trade deficits;

e)     Reduced capabilities in its so-called “toolbox” to fight the next financial crisis.

Simply put, the Fed is at a cul-de-sac: after six years of repressively low interest rates -- bolstered by a bloated balance sheet comprising $4.5 T in assets -- the abnormally fragile recovery points to the need to question some of its fundamental economic beliefs. Chief among them is that an expansionary monetary policy – abundant and cheap credit – is the most critical requirement of renewed economic growth and prosperity.  Is it really ?

In previous recessions economic recoveries had been faster to arrive – without QE – and more robust. This time around, yes, we did avoid a full-scale financial panic, but we are still lacking any proof that monetary policy since 2008 has delivered sustainable growth.

Take the employment scene. Although the unemployment rate has declined measurably, stubbornly stagnant wage-growth across a majority of industries is seriously undermining household consumption from reaching the levels needed for a true economic rebound.

Take business investments. The conspicuous absence of large corporate investments to bolster job creation nationwide casts considerable doubt on the assumptions underlying the Fed’s monetary policies. Yes, low-interest rates have facilitated debt rescheduling and stock buybacks for most large corporations – manifestly benefiting shareholders and no one else in the strictest economic sense – but there is scant evidence that the investment climate for new job creation has improved. If anything, we are witnessing some of the largest corporations threatening to leave the USA in search of preferential tax treatments elsewhere at the expense of domestic employment. (i.e. the highly controversial tax inversion initiatives). It is now clear that those jobs-friendly investment expectations were misplaced.

All of that points to the accepted wisdom in political science which holds a multitude of government policies – not just monetary policy – responsible for economic growth. Monetary policy, without complementary fiscal and trade policies conceived to stimulate the other three supporting pillars -- especially business investment, domestic employment and consumer spending -- doesn’t go very far.

3.2   What if the Fed’s mandate was part of the problem?  

Monetary policy in the US has over the last four decades focused primarily on controlling money supply in order to carry out its dual mandate of maintaining price stability and promoting maximum employment. But, in an interconnected and more complex world of global finance, is maintaining domestic price stability enough?

That dual mandate was granted by Congress in 1977 when runaway inflation was a major political and social concern. By focusing primarily on price stability, the goal was to bring inflation under control in a way to provide broader financial stability which is essential for capital investment and job creation. That operation succeeded for a while.

However, since Fed chair Volcker’s very effective use of high interest rates to combat double-digit inflation in the 1980’s, financial stability has been regretfully equated by politicians, and most financial pundits and academics, with simple price stability described as the “taming” of inflation.The problem is that the low inflation attributed to price stability is a necessary step in attaining financial stability, but it is not sufficient.

There is a lot more to financial stability than subdued inflation in a developed country whose money serves as a global reserve currency. Chief among them is steadiness in the value of its currency. And not too far from it is the predictability in the frequency and severity of shocks that its economy experiences. Measured against both of these criteria, the US monetary policy has badly failed to deliver financial stability.

The US dollar has been in steady decline relative to most other major currencies over the last 15 years -- by well over 40 % against the Euro until recently -- despite the Great Recession. As to shocks or convulsions, we had two major ones in the last decade: the Tech Bust of 2001 and the Great Subprime Crisis of 2007, both of which have been attributed to the loose credit policies of a still mystifying “ we are high-flying, but watch us do a soft landing”  mindset of  former Fed chairman, Alan Greenspan.

But is the real problem the Fed’s performance or the misplaced expectations from its outdated mandate? Should the mandate for the Fed – the central bank behind world’s reserve currency – be reworked to include broader financial stability, especially better and more dependable ways to predict and avoid severe shocks to the financial system?

       

Japan, with a lot more experience with ZIRP and QE since their dreadful asset-bubble burst 22 years ago, serves as a great example as to economic growth in need of  a lot more than subdued inflation. Price stability for an economy mired in structural stagnation is not sufficient. “Growth requires a lot more than monetary policy”, admitted its former central bank Governor Shirakawa in a speech he gave in London back in January 2012 “QE just buys valuable time for mandatory structural changes and nothing else.” he declared, while stressing that loose monetary policy without reforms is not the answer.

Other countries can also provide valuable insights regarding the role and expectations from a central bank. Canada and Israel for instance have experience with mandating higher down-payment requirements – instead of jacking-up interest rates – to deflate speculative real-estate bubbles. Such “macro prudential” curbs, as they are called, are part of the unconventional tools and powers that central banks use for financial stability.

The U.K. serves also as a good example of foresight by explicitly adding the financial stability mandate to the mission of its central bank, the Bank of England, with the Financial Services Act of 2012.

It seems the new vice-chair of the Fed, Stanley Fischer, is particularly attuned to the needs of reworking the Fed’s mandate. By suggesting that Congress should consider making financial stability an explicit mandate for all U.S. financial regulators, he is pointing out the biggest need for change in American monetary policy: a mandate which should go beyond the management of credit and inflation to also include responsibility for financial stability. Otherwise, Alan Greenspan’s suggestion of the inherent “inevitability” of boom and bust cycles in monetary policy is missing an important yet overlooked aspect: accountability.