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Why I Dislike Quantitative Easing?
By Mel Miller

In a previous blog I explained the Federal Reserve’s traditional tool of reducing the Fed Funds rate to stimulate a weak economy.  The stimulation impact is the result of the relationship between the Fed Funds rate and the Prime borrowing rate charged by banks for business and consumer loans.  The Prime rate offered to a bank’s most credit worthy borrowers is 3% above the Fed Funds rate, thus lowering the Fed Funds rate immediately lowers the cost of business and consumer loans.  A lower borrowing rate encourages new borrowing and thus stimulates the economy.

The additional tool utilized by the Fed during the Great Recession was and is Quantitative Easing (QE).  When the conventional method of lowering the Fed Funds rate to the floor proved ineffective, the Federal Reserve initiated QE1 in December 2008 and continues with no stated end date.  The ultimate goal of QE is to drive down long term rates by purchasing long bonds in the marketplace.

The economic decline stabilized to the point that the Chair of the Federal Reserve announced late 2013 that the amount of monthly bond purchases would gradually decline from $85 billion per month.  The new Fed Chair, Janet Yellen, recently announced a continuation of the “tapering,” but did not set an end date for the monthly purchases.  The expectation is that QE will end in the fall of 2014.  Market volatility is likely to increase if the Fed deviates from expectations.

But what is the plan for the massive amount of bonds held by the Fed once QE is over?  Nobody knows.  One of several reasons that I have been critical of QE is this added level of uncertainty.  The Fed has now integrated its influence into “free” markets.  In fact, Fed purchases in some months comprised nearly 50% of the total monthly bond purchases.

Here are a couple of additional reasons that I have been critical of QE:  The Great Recession was anything but “normal.”  It was a crisis brought on by too much debt; therefore, lowering rates to stimulate borrowing was doomed from the start.  A strong case can be made that interest rates were held too low for too long following the recession of 2001-2003.  Consumers especially experienced a change in attitude.  No longer was a house a place to live, it was a ticket to new riches.  “Leverage your home equity to flip additional properties” became the battle cry.  Many people did and even more took out their equity in the form of a home equity loan.  The economy was living on borrowed money.  The bubble began to burst in late 2007.

The debt service ratio reached a record high of 14% since the Fed started tracking in 1980—now the debt service ratio stands at a new low of 9.96%.  Consumers were scrambling to reduce debt no matter what the Fed was attempting to do.  Individuals were trying to restore their savings and were being stymied by the Fed’s attempt to continue to lower rates.  Savers were punished.  The tools that had worked for the Fed in the past, no longer were working.

One could argue that QE1 was essential to reverse the tremendous decline in GDP.  The argument is weakened by the one and only stimulus package approved by Congress impacting the economy at this time.  As highlighted on the graph, GDP growth quickly slowed following the initial comeback.

I remember being taught in college economics classes that monetary policy was never designed to change the direction of GDP, but merely to “fine tune” the economy.  The key driver was and is fiscal policy.  Yet with congressional action mired in political bickering, monetary action was the only game in town.

How did China avoid the world-wide economic collapse?  In a recent paper, Yi Wen and Jing Wu, economists at the St. Louis Fed, argue that China avoided a recession because it implemented an aggressive fiscal stimulus package.  The 4 trillion yuan stimulus package was called “bold and powerful” by the authors.  Of course, when governments interfere with the markets there is always the possibility of unintended consequences.  Such is the case in China.  The misallocation of capital and a bad loan problem has prompted Chinese Premier Li to call nonperforming loans China’s greatest economic challenge.

China has to work through its current debt problem, but it was able to avoid a recession in spite of a 45% decline in exports.  While in the U.S., the Fed will have to deal with the massive unwinding of its bond purchases while the economy has benefited little from the program.

 

Posted: April 21, 2014