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Five myths about the Federal Reserve

By Greg Ip
Friday, November 12, 2010;

The Federal Reserve's announcement on Nov. 3 that it will buy $600 billion worth of Treasury bonds to help boost the struggling U.S. economy reverberated around the world this past week, with condemnation from critics as varied as Sarah Palin and the president-elect of Brazil. Yet much of what the Fed and its chairman, Ben Bernanke, have done is shrouded in confusion and misperceptions.

1. By printing money, the Fed will create runaway inflation.

The Nobel Prize-winning economist Milton Friedman issued a famous dictum nearly 50 years ago: "Inflation is always and everywhere a monetary phenomenon." His belief has become widespread over the years, to the point that even many non-economists assume that when the Fed prints money, higher prices inevitably result. But the link between money and inflation is weaker than people think.

The Fed's current policy of "quantitative easing" essentially means it is printing money ($600 billion) to buy assets such as government bonds. The Fed isn't literally printing the $20 bills that end up in your wallet - it's doing the electronic equivalent. When it buys a $100 bond from a bank, it deposits $100 into the bank's account at the Fed. This electronic money is called reserves, and the Fed conjures it up out of thin air.

However, this money can lead to inflation only if banks lend it and consumers and businesses spend it. Banks lend when they have strong balance sheets and when credit-worthy customers demand loans. People and businesses spend when their incomes are growing and they're confident about the future. None of this has been true lately.

The Fed is trying to stimulate spending, but not by showering people with newly minted dollars. Rather, when the Fed buys bonds, it pushes their prices up and their yields down. Lower long-term interest rates will tempt some people to borrow. They will also make stocks more attractive. Higher stock prices will make consumers feel wealthier and spend more. If that spending outstrips the economy's productive capacity, inflation could result. But that's years away: The economy today is awash in idle factories and unemployed workers.

2. The Fed is endangering the global recovery by trying to drive down the dollar.

Since Chairman Ben Bernanke hinted in late August that the Fed might resume quantitative easing, the value of the dollar has fallen steadily, dropping 7 percent against the euro, 3 percent against the yen and 7 percent against the Korean won. Many foreign officials and analysts have accused the Fed of deliberately driving down the dollar to give U.S. exporters a competitive advantage abroad.

The truth is more complicated. If the Fed had an explicit policy of devaluing the dollar, it would sell dollars on the open market, buying foreign currencies in return. However, the Fed does this only with the Treasury's consent. The Fed hasn't sold dollars since 2000.

But while a weaker dollar isn't the direct goal of the Fed's actions, it's a predictable and welcome consequence. When the Fed eases monetary policy - either by lowering short-term rates or, nowadays, by forcing down long-term rates with bond purchases - it makes Treasury bills and bonds less appealing. Investors flock to alternatives, including foreign stocks and bonds, driving up other currencies relative to the dollar. The lower dollar complements lower interest rates in spurring economic growth.

This is a zero-sum game. As a falling dollar boosts American exports, it hurts the exports of our trading partners. But that's as it should be. After years of living beyond its means, the United States must now save more and consume less. That means its trade deficit has to shrink. Countries such as China that piled up huge surpluses with the United States must do the opposite.

It's also a risky strategy. The surge of investment in foreign assets could produce dangerous bubbles. Speculators could drive commodity prices so high that consumers could be hammered worldwide. Worse, countries unhappy about a flood of imports could turn to protectionist policies.

3. The Fed is trying to finance the government's profligacy.

By buying Treasury debt, the Fed is in effect financing the federal deficit. This raises alarms: Hyperinflation in countries such as Zimbabwe or Weimar Germany occurred when private investors wouldn't lend to the government, so the government printed money to finance its spending.

But that's not what's happening here. Even with our budget deficit as a share of GDP near a post-World War II record, there's no shortage of private and foreign investors to buy Treasury bonds.

It will be time to worry, though, if the Fed keeps buying bonds in the face of rising inflationary pressure simply to keep the federal government's borrowing costs down. At present, the economy is so weak and inflation so low, it might actually help if the government borrowed more. But that's not going to happen. Political gridlock makes an additional federal stimulus pretty unlikely, and Fed officials don't want to be seen as servants of the Treasury.

4. The Fed is immune to politics.

If only it were so. The Fed is technically independent from the rest of the government, but presidents and Congress have ample ways to pressure it. They can privately and publicly browbeat the chairman, withhold his reappointment, appoint compliant governors or amend the Federal Reserve Act.

Like Bill Clinton and George W. Bush before him, President Obama has respected the Fed's independence. Yet Bernanke must still walk a political tightrope. He has long wanted to set an explicit inflation target (probably 2 percent per year) but hasn't done so, partly because of opposition from some in Congress who worry that focusing on such a target would come at the expense of job creation. The radical steps Bernanke took during the crisis to prop up the financial system angered many lawmakers; the chairman may be reluctant to ramp up quantitative easing for fear of further inflaming those critics.

Obama reappointed Bernanke last year and has been solidly behind the Fed. But for how long? The time will come when Bernanke must tighten monetary policy. Chances are, it will be sooner than Obama wants. Will his support be as unwavering then?

5. Bernanke knows what he's doing.

Bernanke came to his job with an impressive resume, including years of studying the Great Depression. To that he can now add the irreplaceable experience of running the central bank through one of its most harrowing periods. If anyone should know what he's doing, it's him.

Unfortunately, the Federal Reserve's history is littered with mistakes, from those that led to the Great Depression in the 1930s to those that brought on stagflation in the 1970s. The Fed is the most powerful financial regulator in the United States and employs hundreds of economists, supervisors and lawyers, yet it had almost no idea how vulnerable the financial system had become to a collapse in housing prices.

It would be nice if we could isolate these errors to ensure that they never happen again. But the global economy is complicated and always changing, and the Fed can never be certain of the consequences of its actions. Has it now gone too far, fueling reckless speculation, inflation and global trade tensions? Or has it not gone far enough, inviting stagnation and deflation? No one knows for sure - Bernanke included.

Greg Ip is the U.S. economics editor at the Economist and the author of "The Little Book of Economics: How the Economy Works in the Real World."

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