A Look At Monetary Policy
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As we slog through yet another year of mediocre economic growth and a weak job market, I thought it might be a good idea to take a closer look at the monetary policy instituted by the Federal Reserve System (the Fed) during this time period. The policy has not only been huge by historical standards and unprecedented in scope, but it has been highly controversial. Many have questioned its effectiveness or railed about its inflationary potential.
Fed Policy Actions
In response to the recession and financial crisis, the Fed lowered its primary policy tool, the federal funds rate, in a series of steps from 5.25% in August 2007 to essentially zero by the end of 2008, where it remains. The Fed has indicated that it will leave its target at this rate at least through the middle of 2015.
With the economy failing to respond in the hoped for manner and with the central bank’s primary instrument set at zero, the Fed needed another way to stimulate the economy. It turned to quantitative easing. This program involved purchases of debt directly from the financial system and was given the moniker “QE1.”
In November 2008, the Fed announced a goal to purchase $100 billion in
government-sponsored enterprise (GSE) direct obligations and $500 billion in mortgage-backed securities (MBS). With the economy still not responding as hoped, the Fed extended the program in March 2009 and announced an additional $100 billion in GSE debt, $750 billion in MBS, and $300 billion in longer term treasury securities.
In November 2010, the Fed instituted what became known as “QE2” when it announced the purchase of an additional $600 billion in longer term Treasury securities by the end of the second quarter 2011, at a rate of $75 billion per month. Yet again, the economy remained stuck in its subpar growth rate, triggering another extension of QE1 and QE2 and the addition of “Operation Twist” in September 2011.
Operation Twist was intended to bring down longer term interest rates with the purchase of $400 billion of Treasury bonds with maturities of 6 to 30 years and sell an equivalent amount of short-term (maturities shorter than three years) securities. This program was extended in June of this year, at which time the Fed added another $267 billion through 2012.
QE3 was announced in September 2012. In contrast to earlier policies, QE3 is an open-ended purchasing program worth $40 billion per month for an undisclosed time period.
In addition to lowering interest rates to zero and all the asset purchases, the Fed changed a little known policy on reserves held at the Fed. It requires that banks hold a small percentage of their demand deposits as reserves at the Fed. These reserves are used to facilitate account clearing, and banks usually hold a bit extra beyond the required amount to be on the safe side. These reserves traditionally did not pay interest; so banks kept only a small amount—about $2 billion for the entire banking system. In October 2008, the Fed changed this policy and agreed to pay banks a very small rate of interest of 0.25% on these accounts. This small change has had profound results as we will see a bit later.
The Fed’s unprecedented actions have increased bank liquidity by almost $2.0 trillion, and the continued purchases will do even more. Interest rates are at rock-bottom levels, and risk spreads are close to prerecession levels. The financial markets are more liquid and stable than at any time in the past four years, but the real economy is still stuck in second gear managing only 2.2% growth since the recovery began and creating perilously few jobs. So were the Fed’s actions a failure? To answer this question, one must look below the surface and beyond GDP and job growth.
The lower interest rates have reduced consumer debt service costs by over $200 billion annually, increasing discretionary income and allowing consumers to spend more on goods and services. Its impact is similar to a tax cut of the same size. This has helped shore up consumer spending. It is also why the Fed is unlikely to reverse its interest rate policy anytime soon.
Critics are fond of pointing out that the Fed’s asset purchases have failed to produce much in the way of new lending and that many in the economy are still starving for credit. While this is true, much of the reason that bank lending is still low can be laid at the feet of stricter lending standards, harsher regulations in the wake of Dodd-Frank, higher capital ratios, and reduced demand, rather than on a lack of Fed credit.
The real success of the Fed policy is the fact that we still have a viable banking system. In 2008, banks were suffering huge losses, primarily due to the collapse of the housing bubble. Bank capital was eroding, and liquidity was evaporating.
Bank profits were only $4.5 billion in 2008, down from nearly $100 billion in 2007. Liquid assets (cash and securities) were $3.1 trillion (22.3% of total assets), and the banking system’s share of tier 1 capital was 7.2%, down slightly from 7.6% in 2007.
The asset purchases by the Fed have injected about $2.8 trillion. Much of this amount, about $1.4 trillion, made its way back to the Fed in the form of excess reserves. These excess reserves not only serve as liquidity, but because of the interest that the Fed pays on these reserves, they generate about $35 billion of bank profits, which help increase capital and stabilize the banking system.
The result is that bank profitability has risen, banks are better capitalized, and they have more liquidity. Bank profits rose in the first half of 2012 to $69 billion, in line with historical averages. Liquid assets have increased to $4.3 trillion (30.6% of total assets), and banks’ share of tier 1 capital has increased to 8.9%.
As a student of the Great Depression, Chairman Bernanke obviously understood the harm caused by wholesale failures in the banking system as witnessed in the early 1930s, and he was determined to avoid a repeat performance.
This type of extraordinary monetary policy can present problems. The most obvious is inflation. The sheer magnitude of the asset purchases suggests that if these aggressive purchases were to suddenly find their way into increased bank lending and increases in the money supply, they could quickly go from stimulating growth to increasing prices. Of course, if the data suggested that this were happening, the Fed would likely reverse the process. But this raises three important questions: Would the change be evident from the data? Would the political process encourage a more restrictive monetary policy? And could the Fed withdraw the liquidity at the appropriate rate? If the Fed pulled back too quickly, we could see another recession, and if it pulled back too slowly, inflation could get a foothold. That is a lot of “ifs”!
Brian Higginbotham, U.S. Chamber economist, is the primary author of this article.