Quantitative Easing: It’s effect on the dollar, the economy, and inflation (published in October of 2010 in the SB News Press)

The Fed met this week to discuss their options in terms of helping the economy.  Federal Reserve Chairman Bernanke stated that there was a strong “case for further action” on the part of the Fed, on the monetary policy front, although he did not specific what or when they might take this further action. 


Given the current level of short-term interest rates, and the tepid response we have witnessed from the economy thus far to the actions the Fed has taken, including lowering rates basically to zero, there appears to be few remaining options the Fed could take that would have any real impact.  In fact, I am not certain that there is anything they can do to help (although there are a lot of things they could do that could very well hurt the economy, and things they have already done that may hurt it).

In this week’s column, I will explore the options remaining for the Fed—namely quantitative easing—and the possible results and consequences of this action.  I will also discuss some of the current problems we face that already exist, that have resulted from past actions of the Fed, and as a result of the recent recession.

Quantitative easing (QE) is a fancy way of saying that the Fed will buy securities, such as treasuries and mortgage-backed securities.  As they buy these securities, they pump cash into the economy.  The hope is that, by pushing cash into the hands of people, companies, and institutions; that economic activity will increase.  Further, they hope that banks will lend.  Japan recently began using quantitative easing, but for a slightly different reason, which is to weaken their currency (more on this below).  Their desire to weaken their currency, however, is because they want to stimulate their economy.

Bernanke, in his statement released after the Fed meeting this week, said that the current high unemployment/low inflation environment would exist well into 2011.  He was not clear about the specific intentions of the Fed, and backed a cautious approach, only adding that the Fed expects keep interest rates “low for longer than the market expects.”

Normally the Fed will use lowering interest rates as their primary tool for stimulating the economy, to help us lessen the severity of a recession, and to pull us out of recession into recovery.  Unfortunately, because the recent recession was so intense, even with the Fed dropping rates to zero, it has not been enough.  Short of paying institutions to borrow money, the Fed is out of room to lower rates, which means that their strongest tool is now off the workbench.

The problem with quantitative easing is that it is a blunt instrument at best.  It is difficult to accurately predict what impact (if any) pumping even as much as $1 trillion would have on the economy.  For this reason some Fed officials are opposed to QE.  The Fed will meet in early November to discuss the economy and what, if anything they will do.  My guess is that they will employ some QE; possibly as much as $250 billion to $500 billion (to start).

Consequences

Probably the most dangerous possible consequence of QE is inflation.  By pumping more money into the economy, demand for goods and services should increase.  Higher demand is good for economic growth, and right now, it is what we need.  But too much demand will create steady price increases that can get out of control very quickly. 

One other aspect of QE and of inflation is a weakening dollar.  As mentioned above, Japan is trying to purposefully weaken their currency.  The problem with a weak currency strategy is that currencies are only weak or strong as compared with other currencies.  For example, the Japanese yen is strong against the dollar and euro right now, or you could say the dollar and euro are weak against the yen.  This is bad for Japan because it means that the good and services they produce are more expensive in dollars and euros—it takes more dollars and euros to buy things in yen, so it is basically like Japan’s prices have been raised for U.S. and European buyers.  Higher prices mean less sales, and less sales means a weaker economy. 

The problem with trying to bring the value of a currency down, as Japan is trying to do right now, is that the other countries don’t like it.  The last thing the United State of Europe want is for their currencies to become more expensive.  Our economy is weak already, so we do not want to make our goods and services more expensive right now. 

From this perspective, QE here in the U.S. would make some sense, because it will weaken the dollar.  To the extent that we want to keep the dollar weak right now, QE appears to be a good strategy, and is certainly part of the reason the Fed is considering using QE.  The problem again is that weakening the dollar can lead to out of control inflation.

One other tricky aspect of everything the Fed does is the lag time between when they make a decision or take an action, such as QE, and the actual impact that action will have on the economy.  It normally takes from two to four quarters for Fed actions to take effect.  This means that the Fed is constantly guessing where the economy will be in six to twelve months, and then is making policy decisions, like using QE, based on those guesses.  Obviously this is not an exact science, and the process is, therefore, rife with heavy risks. 

The most prominent downside risk to QE is that inflation gets out of control, and the Fed is forced to raise interest rates aggressively, as Paul Volcker did in the early 1980s.  Inflation peaked at 13.5% in 1981, and was brought under control through very aggressive interest rate increases, to a peak of 20% by June of 1981.  By 1983, inflation had falling to 3.2%.  The problem was that, as a direct result of these interest rate increases, Volcker crushed the economy, and we had one of the worst recessions in U.S. history, including double-dip recessions, (which I have already written about). 

With the time lag between the decision to use QE and the actual impact of it, coupled with the fact that interest rates are already at zero percent and have been there for a long time, the risk of inflation, in my opinion, is probably at its highest in the history of this country.

What concerns me most is that we have just been through the worst recession since the Great Depression, and if we are pushed back into recession because the Fed is too aggressive about using QE and keeps rates too low for too long, we will have an extremely long, painful, slow process of working out of the recession, which could take a decade or longer. 

Admittedly this is a worst case scenario.  The Fed officials making these decisions are some of the smartest economists on the planet, and have done their homework.  My hope is that they make the right decisions and achieve the economic growth we all wish to see without blowing things up in the process.  It would be great if there was an historic precedent for the current economic situation, but there is not.  With uncertainly comes risk, and unfortunately that risk is significant, and impacts every one of us.
Tags:

Leave a Reply

Your email address will not be published. Required fields are marked *

ERROR: si-captcha.php plugin: securimage.php not found.