Expectations. It's all about expectations.
There's nothing more confusing than monetary policy, and nothing more confusing about monetary policy than quantitative easing. Even to Harvard professors.
There are two things you need to know about the Federal Reserve right now. First, it's had to resort to unconventional measures ever since short-term interest rates, its usual policy lever, fell to zero back in 2008. And second, everything you've been told about these unconventional measures has been wrong. The wrong story you've heard goes something like this: Since it can't cut short-term rates anymore, the Fed has cut long-term rates by buying long-term bonds, which goes by the confusing name of "quantitative easing". (Remember, bond prices and yields move in opposite directions). Lower borrowing costs should mean more borrowing, and more borrowing should mean more growth. Voilà, virtuous circle!
It's the same story you always hear about the Fed, just with long-term rates substituted for short-term rates, and it's the one Harvard professor and former Reagan adviser Marty Feldstein
tells in the Wall Street Journal
. Well, kind of. Feldstein worries this story has some unintended consequences -- namely, higher deficits and higher inflation -- that will give it an unhappy ending. He thinks the Fed pushing down long-term rates only enables more government spending than we can afford now, and sets us up for more inflation than we want later. Nobody's ever been accused of being facile for talking about unintended consequences, but, well there's a first for everything. The problem with Feldstein's argument is it ignores all empirical evidence, and, in the process, gets things completely backward. Quantitative easing doesn't lower interest rates. It raises them
You can see that plainly enough in the chart below. It looks at the yield on 10-year Treasury bonds the past few years, and annotates it with a guide of the Fed's unconventional policies
. Borrowing costs rise almost every time the Fed buys bonds, and fall almost every time it stops.
Welcome to the other side of the looking glass. Things will begin to make more sense once you realize monetary policy is more about expectations than interest rates. The latter just tell us about the former, especially when it comes to quantitative easing. Remember, buying bonds should
lower interest rates, but it doesn't when it's the Fed doing the buying. It doesn't because the Fed isn't really buying bonds as much as it's sending a message that it wants more growth. That makes bonds less attractive -- who wants a fixed return when business is booming? -- and pushes up borrowing costs more than buying bonds pushes them down. In other words, the expectation of lower interest rates leads to higher interest rates. As Matthew Yglesias
points outs, that's exactly what's happened in Japan recently, where the new prime minister's promise of a more aggressive central bank has been enough to send borrowing costs surging.
In short, Ben Bernanke has made it more expensive for the government to borrow money. And that's good news. Just consider the counterfactual where there was no quantitative easing. Asset prices, like stocks and homes, would almost certainly be lower, and that would make households try to save more. That doesn't exactly sound like a problem, but it would be a massive one right now. In normal times, savings gets turned into investment, but we don't live in normal times; desired savings has outpaced desired investment. That's why we're in a slump. The chart below, from Martin Wolf
of the Financial Times
, shows just how much the private sector shifted from borrowing to saving when the crisis hit in 2008.
But everybody can't save at the same time. Your spending is my income, and vice versa, so if we all try to save at once, the unhappy result will be less income for us all -- and less income means less overall saving than we would have otherwise had. It's what Keynes called the paradox of thrift, and it has two fiscal corollaries. Increasing desired savings in a liquidity trap will 1) increase deficits, and 2) decrease borrowing costs. The former will go up because a weaker economy means lower tax revenues and more spending on automatic stabilizers like unemployment insurance; the latter will go down because a weaker economy leaves investors with no better place to park their money than government bonds. Far from facilitating bigger deficits due to lower interest rates, quantitative easing reduces deficits and raises interest rates, at least compared to a world without quantitative easing.
Then there's inflation. There's not as much to say here, because Feldstein's worries are entirely hypothetical. Yes, the Fed's balance sheet has swollen to an unprecedented size, but, no, that does not necessarily condemn us to a stagflationary nightmare of a future. Far from it. In theory, banks might want to lend out their $1.4 trillion or so of excess reserves
when the economy recovers, but in practice there's plenty the Fed can do to forestall such an inflationary wave. It can increase the interest it pays on reserves, or do reverse repos with banks, or use its term auction facilities -- all of which, in English, amount to paying banks not to lend. More simply, it could increase the reserve requirement for banks, so those excess reserves just become reserves. In any case, markets aren't worried -- 5-year inflation expectations
are hovering right around 2 percent.
There isn't a more maligned or misunderstood policy than quantitative easing. Scaremongers from Zerohedge to bond guru Bill Gross to Harvard professor Marty Feldstein have told us it subsidizes mega-deficits by pushing interest rates "artificially" low, and risks turning us into Zimbabwe, but the opposite is true. Quantitative easing lowers deficits, raises interest rates, and hasn't even pushed inflation above the Fed's 2 percent target. Now you know, and knowing, in this case, is all the battle.