Fed shouldn’t turn off the tap

The Federal Reserve has been pursuing unorthodox monetary policies for the past four and half years to counter the after-effects of global financial crisis which had its epicentre in US.

With a recovery not happening at the desired pace, the central bank has been trying different policy instruments to support the economy. The standard tool for the Fed is to declare the targeted Federal Funds Rate, which it tries to achieve by undertaking open market operations.

Quantitative Easing

Just to set the context, aWhen the Fed wants to boost economic activity it sets the federal funds rate lower. Following the financial sector crisis, the Fed committed itself to a near-zero federal funds rate.

The targeted range for federal fund rate has been between zero and 0.25 per cent since December 2008. Having lost its powers to lower interest rates any further and with the recession being no ordinary one, the Fed tried to pursue unorthodox policies like quantitative easing and ‘Operation Twist’ to revive the economy.

After the collapse of Lehman Brothers, the Fed pumped money to address liquidity needs in the financial system and address recession in the US. The first round of quantitative easing (QE-1) was pursued from December 2008 through March 2010, during which Fed pumped dollars to the system by purchasing long-dated treasury and mortgage backed securities worth $2.3 trillion. By the quarter ended March 2010, growth had turned positive, unemployment was at 10.2 per cent and inflation had reached 2.1 per cent, approximating Fed’s level of comfort.

The Fed discontinued with QE-1 despite very high levels of unemployment, given the price pressure. However, in the following two quarters, inflation declined significantly. The Federal Reserve in August 2010 felt there was a good chance that the economy would again be back to recession and deflation may set in.

To avoid deflation, the Fed initiated QE-2 during November 2010-June 2011. Another motivation for QE-2 was to provide support to the US economy from financial instability arising out of sovereign debt crisis in Europe. It was thought that by making liquidity available quite cheaply, firms will borrow funds to make investments, and consumers will also be enticed to spend. This will help to prevent deflationary tendencies. Moderate inflation is desirable as it greases the wheels of the economy. Fed has been successful in controlling deflationary tendencies through QE-II.

Core inflation crept to levels substantially higher from the levels seen before QE-II to 3.4 per cent by the quarter ended June 2011. However, the wider benefits like spurring growth and reducing unemployment through investment did not materialise after QE-II.

Operation Twist

Unemployment in US was 9.3 per cent and growth was modest at 1.9 per cent in the quarter ended June 2011. It was thought in some circles that the Fed may come up with another round of liquidity pumping through QE-3 to avoid a double-dip recession. Instead, the Fed used another unorthodox instrument, operation twist (OT).

OT was first tried in US in the early 1960s but there is no clear evidence that it helped at that time in exerting significant downward pressure on long-term interest rates. Under OT, the Fed will buy long-term government bonds and sell short-term securities to the tune of $400 billion. On the one hand, by purchasing, the price of long term bonds will increase, driving down their yields. On the other, by selling, the prices of short tenure government bonds should decline and their yields increasing.

An important feature of OT was that unlike QE, it did not infuse additional liquidity into the system but was expected to promote long-term investment by keeping long-term interest rates relatively low compared to the short-term rates. The conduct of OT was accompanied by increased the pace of growth, downward pressure on inflation, but limited impact on unemployment.

Given the high unemployment levels, Fed decided to dispense with OT and pursue a stronger version of QE, which will continue till the unemployment situation improves significantly. The Fed launched QE-3 in September 2012 which is in operation till now. However, Bernanke has recently indicated that if a growth revival gains momentum and the unemployment situation improves significantly, the Fed will scale down its asset purchase programme from the end of 2013.

INFLATIONARY OUTCOME

In all, the Federal Reserve’s balance sheet has expanded from slightly less than a trillion dollars in late 2008 to as much as $3.5 trillion now -- as of June 12, 2013. As the US is exposed to a fiscal squeeze equivalent to 1.75 per cent of GDP, the Fed should support the economy more vigorously.

Some observers feel that the Fed, which was supporting the economy by infusing liquidity, has changed its mind to guard against possible inflationary consequences in the medium term, which will make the revival much weaker.

The Fed has already erred on previous occasions by prematurely stopping QE. Given the state of the macro economy in the US and the lack of consensus on fiscal policy, it may be a better idea to continue with unorthodox instruments for longer.

The author is Economics Professor, Xavier Institute of Management, Bhubaneswar. The views are personal.

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