The Fed Still Has Ammo
It hasn’t been an easy time for the Federal Reserve. The impact of last year’s quantitative easing program (QE2), in which the Fed purchased Treasury bonds to keep interest rates low, has been disappointing. Economic growth has stalled, and unemployment remains stubbornly high. Nevertheless, it’s wrong to think that the Fed has spent all its bullets and can no longer stimulate the economy. And it’s particularly wrong to beseech the central bank to refrain from any further intervention, as some critics have done.
We can’t rewind world events and see how the economy would have performed without the Fed’s aggressive policies, but we can look at history. After the 1929 stock market crash, which precipitated a credit crisis similar to our subprime mortgage crisis of three years ago, the Fed stood by and did nothing—no extra reserves loaned to banks, no quantitative easing to inject liquidity into the system.
The results were disastrous. The real economy collapsed as real gross national product plummeted by 27%, the unemployment rate soared to more than 30% by today’s measurements, and 25% deflation dealt a crushing blow to those in debt. The economy didn’t recover to its pre-Depression level until more than a decade later.
By comparison, the current economic situation shines. In the Great Recession, gross domestic product fell by only 5%, and output has almost recovered to pre-crash highs. The unemployment rate just touched 10%, and price levels have remained steady. Clearly, the Fed’s aggressive moves to provide reserves that kept the banking system intact and the financial markets functioning have made the difference between then and now. And thanks to the Fed, the U.S. has fared better than other countries whose central banks—think the Bank of England and the European Central Bank—have not pursued similar policies.
More bullets. The latest Fed initiative, dubbed Operation Twist, has succeeded in lowering long-term interest rates and sending the 30-year mortgage rate to a new low. And the Fed still has another bullet in its belt. It can reduce the interest rate it pays banks on their excess reserves from the current one-fourth of 1% down to zero. The current rate is more than twice the rate on one-year Treasury bonds and gives banks little incentive either to invest their reserves or lend them out. Charles Plosser, president of the Federal Reserve Bank of Philadelphia and a dissenter to the previous two Fed policy moves, has indicated he might favor this strategy.
And let’s not abandon QE2. Although the quantitative easing completed last June did not spur the economy, it did boost stock prices and reverse the deflationary trends in the economy. It hasn’t led to greater economic fluctuations and uncertainty, as Fed critics claim. In fact, inflationary expectations are approximately the same as they were at the start of QE2 more than one year ago.
The Fed’s limits. Although the Fed can do a lot, it can’t do everything. Its main role is to keep inflation in the range of zero to 2% and provide liquidity in times of crisis. It can’t spur growth in productivity, stop excessive government regulation or fix the deficit problem. And it should not be used as a substitute for sound fiscal policy. I believe that entails long-term deficit reduction, combined with continuing short-term tax relief, such as extending and enlarging the payroll-tax reduction through 2012.
Republican critics in Congress are right when they say that the U.S. economy is ultimately driven by the confidence of consumers and investors and by the innovation of workers—and, I would add, entrepreneurs. I am sure that Fed chairman Ben Bernanke also believes this. But that doesn’t mean the Fed shouldn’t use all the tools at its disposal to help achieve these goals sooner rather than later.