Legendary economist John Maynard Keynes is known to have supported his economic theory calling for short-term government stimulus during a recession through the statement, "In the long run, we're all dead." It was the classical economists who argued that the market will always reach equilibrium on its own in the long-term, but Keynes found patience unpalatable. In a speech today in Denver, maverick Kansas City Federal Reserve President Thomas Hoenig made clear that he disagrees with Keynes. He argued that the Fed should resist the temptation to engage in additional quantitative easing ("QE2"), because it could have disastrous long-term consequences and only modest short-term benefits.
Towards the beginning of Hoenig's speech (.pdf), he makes clear that the Fed's directive to maximize employment does not necessarily require monetary expansion whenever unemployment is high:
There is, within the Act, a clear recognition that our policy goals are long-run in nature. In this way, the Act recognizes that monetary policy works with long and variable lags. Thus, the FOMC should focus on fostering maximum employment and stable prices in the timeframe that monetary policy can legitimately affect - the future. The FOMC must be mindful of this fact and be cautious in pursuing elusive short-term goals that have unintended and sometimes disruptive effects.
He then moves on to argue that QE2 isn't likely to be very effective anyway. He says that, considering that the financial system is already functioning relatively well, it might only take 10 to 25 basis points off longer-term rates. That, he says, won't do much to lower unemployment. Instead, banks will just take that additional money in the system and continue investing in and then hoarding safe securities like government bonds, rather than lend, until the recession has more clearly dissipated.
Yet, more monetary expansion would have significant risks, according to Hoenig. He names three.
First, he worries that as the Fed increases the size of its balance sheet more aggressively, it won't have as much flexibility to change direction. The consequence would lead to "a further misallocation of resources, more imbalances and more volatility." He wonders when or how the Fed will know that enough asset purchase are enough. Must unemployment recede to a certain level, or is it when inflation increases to some specific rate? He wants a clear exit strategy.
Second, he thinks QE2 undermines Fed independence. When the Fed purchases assets, taxpayers are stuck with more risk. The Fed also implicitly picks winners, because it must decide to purchase certain securities instead of others. This is especially problematic when buying Treasury bonds, which allows the government to fund its deficit spending without a market check.
Third, he generally fears what inflation will look like once the economy recovers. He suggests that it could hit 4% or 5%. Since the Fed's balance sheet would be deep in unchartered territory, the market might expect that much higher inflation is inevitable as deficits remain large and the Fed monetizes government debt.
So what does Hoenig suggest instead of QE2? He wants to tighten monetary policy. First, he wants to allow the Fed's current assets to run off, instead of reinvesting them. Next, he wants to begin to slowly raise interest rates, noting the damage that extremely low rates did in 2003 by helping to inflate the credit bubble.
In general, Hoenig worries that leaving interest rates near-zero indefinitely and purchasing additional assets may distort the economy in the long-run. He recognizes that high unemployment is a problem, but simply believes the economy would be better off if the Fed worked to instill confidence by employing a more sustainable monetary policy. Even if QE2 does help bring down unemployment a little in the short-run, he fears it could lead to a lot of major problems in the long-run.
While these points are strong, they might not matter. Hoenig has been the lone dissenter voting against expanding monetary policy on the Fed's Open Market Committee for months now. It's not very likely his colleagues will suddenly join him and move to reverse expansionary policy.
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