Economics One

Today’s FOMC meeting and press conference clarified to some degree how large the Fed intends to let its balance sheet grow under quantitative easing.   Under the FOMC’s current economic outlook, the Fed intends to slow, before the end of the year, the pace of bond purchases from $85 billion per month and stop the purchases by the middle of next year.  With the FOMC’s forecast for the unemployment rate around 7% in the middle of 2014, this also clarifies that the criterion for ending QE is explicitly different from the 6.5% unemployment criterion for the commitment to the zero interest rate policy.

The impact of this new view can be assessed with the following chart of reserve balances (which I have used on this blog and in congressional testimony).  To finance large-scale bond purchases, the Fed credits banks with these reserve balances (deposits at the Fed), so they closely track purchases under QE. The chart illustrates how unprecedented the Fed’s recent policy has been, not only compared with the response to the physical damage in 9/11/2001 but also in comparison with the liquidity provisions during the panic of 2008.

The red line shows a projection consistent with the assumption that the $85 billion would continue until the unemployment rate hit 6.5 % (which until today was one interpretation of the “substantial labor market improvement” criterion) in which case tapering would have started in mid-2015.  Note that this is essentially a continuation of the recent history (blue line).

The black line shows a projection consistent with the new view that was expressed today. Although we still do not know what the degree of slowing will be, the chart assumes that the pace is cut in half (to $42.5 billion per month) in October and then to zero in the summer of 2014.  If this is what actually transpires, reserve balances will peak around $2.8 trillion rather than $4.2 trillion under the previous projection. That’s a big revision.  Markets likely had already been assuming (at least since Bernanke’s Joint Economic Committee hearing a month ago) a tapering before the middle of 2015.  Still that downward revision is larger than the total increase in reserve balances under QE3.

Ever since QE3 began I have been giving lectures pointing to the red line, hoping it would not happen, and asking, as in the story of Scrooge, “Are these the shadows of the things that will be…. . . or are they the shadows of things that may be, only?”  The new projection is less scary, and that is something to be grateful for.  Still even though the peak is lower than one might have feared, exit from that peak will be very difficult for the Fed as the market volatility for the past month has shown as various Fed officials have endeavored to broach the subject. Unfortunately, Fed policy makers are still not clear about the exit and they are far from what Justin Wolfers recommends that they: “Tell us what they are going to do, then follow through by doing it.”

Paul Krugman’s reply to my post on Allan Meltzer’s and Paul Volcker’s critiques of monetary policy failed to mention what Paul Volcker has been saying. Yet Volcker’s views are important, especially since, as Krugman points out, he “deserves immense respect for past achievements.”

In his recent Economic Club of New York speech (which has been under-reported and deserves to be read carefully), Volcker argues that the “Beneficial effects of the actual and potential monetization of public and private debt, the essence of the QE program, appear limited and diminishing over time.  The old ‘pushing on a string’ analogy is relevant.  The risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention.  All of this has given rise to debate within the Federal Reserve itself.  In that debate, I trust sight is not lost of the merits – economically and politically – of an ultimate return to a more orthodox central banking approach.”

Like many others, Volcker is pointing to a two types of risk:  speculative distortions and inflationary potential.  Inflation, even if down the road, is not the only problem. There are already distortions caused by the unprecedented interventions in the mortgage market, the Treasury bond market and the inter-bank loan market, including the multi-year zero interest rate administered by the Fed.

It is also important to note, as I did in my earlier post, that Volcker is critical of the Fed’s dual mandate, which he says is “operationally confusing and ultimately illusory: operationally confusing in breeding incessant debate in the Fed and the markets about which way should policy lean month-to-month or quarter-to-quarter with minute inspection of every passing statistic; illusory in the sense it implies a trade-off between economic growth and price stability, a concept that I thought had long ago been refuted not just by Nobel prize winners but by experience.”

During his chairmanship of the Fed, Volcker found a way to deal with this dual mandate and still run a reasonably predictable monetary policy.  More recently the Fed has used the dual mandate to rationalize a less predictable and more interventionist monetary policy.

It’s unusual for former central bankers to speak about current monetary policy, yet Volcker is not the only one to do so. In a recent CNBC interview, Alan Greenspan also raised concerns about current policy saying:   “The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve, which everyone agrees is excessive, the better.” and “The issue is not only a question of when we taper down, but when do we turn?  And I think that the markets may not give us all of the leeway we would like to do that.”

In a new piece called “Quantitative Quicksand” published in Project Syndicate, Allan Meltzer argues that the U.S. recovery would be better off if the Fed had not engaged in quantitative easing.  The banks are just loaning the extra liquidity to credit worthy borrowers and the government, rather than to the smaller businesses that need it.  The economic problems lie elsewhere. In the meantime the risks of not being able to exit smoothly from the Quantitative Quicksand (what a great title) are mounting.

Meltzer is one of many economists and policy makers—on both sides of the political spectrum—who have been speaking or writing on the risks and the already-realized downsides of the Fed’s recent policy.

Just last week Paul Volcker weighed in at the Economic Club of New York, arguing that the exit problems are indeed tough while the benefits of the policy are “limited and diminishing.” Volcker also makes the case for getting rid of the dual mandate because of the risks it too causes. The recent market volatility over tapering—exiting from the quicksand—is just an early realization of the risks that many have long been warning about.