Wednesday, October 20, 2010;
ON NOV. 2, voters go to the polls -- and, perhaps as important, the Open Market Committee of the Federal Reserve Board convenes in Washington. All indications are that the Fed will embark on a major effort to stimulate the economy. With unemployment still high and inflation threatening to become deflation, Fed Chairman Ben S. Bernanke seems to believe that the Fed should act, lest the economy slip into permanent, Japan-like stagnation -- or worse. His determination is laudable but risky. The unorthodox approach he seems to favor could easily have negative side effects.
The Fed has exhausted its usual means of increasing the money supply: lowering the interest rate at which banks may lend one another their reserves held at the Fed. This so-called federal funds rate is now zero. You can't go any lower than that, so the Fed has expanded the money supply further through "quantitative easing": buying more than a trillion dollars' worth of mortgage-backed securities with freshly printed money. Now the Fed is poised for more such "quantitative easing" -- market mavens call it "QE2" -- in an effort to bring long-term interest rates down further.
The case for QE2 is straightforward. By bidding up the price, and thus lowering the yield, of Treasuries and other safe debt instruments, the Fed encourages investors to put their money into different, potentially higher-yielding investments such as stocks. This reduces the cost of capital for businesses, which enables them to expand, which creates jobs. Other hoped-for effects include a further slide in home mortgage rates and greater demand for U.S. exports. A student of the Great Depression and Japan's recent deflationary woes, Mr. Bernanke has long believed that those disasters could have been avoided through timely, aggressive central bank intervention. After QE2, no one will be able to accuse him of sleeping on the job.
But QE2 is a gamble, as Mr. Bernanke acknowledges. "We have much less experience in judging the economic effects of this policy instrument," he said on Oct. 15, "which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public."
The risks include, crucially, a surge in commodity prices, which have already taken off in anticipation of QE2. Higher prices for food and gasoline would cancel out some of the growth QE2 might achieve. A cheaper dollar might indeed help exports -- or it could set off asset bubbles in emerging markets and trigger competitive devaluations by U.S. trading partners. Though inflation remains well below the Fed's target of roughly 2 percent, it's not clear how the Fed will sop up all the extra liquidity it's creating once growth resumes.
The deeper fear is that QE2 is a cyclical solution to a structural problem. Many corporations are flush with cash already but simply don't see enough opportunities for profitable investment within the United States. The list of reasons include households with too much debt; political and policy uncertainty; a growing mismatch between the skills of unemployed U.S. workers and the available work; and a broader shift in economic dynamism from the developed to emerging markets.
It's worth remembering that Mr. Bernanke, like many others, hoped that one round of quantitative easing, plus fiscal stimulus, would be enough to turn the economy around. He now says that the Fed will "proceed with some caution" toward QE2. Given the uncertainties, that's a promise we hope he'll keep.