Monetary Policy, Deflation, and Quantitative Easing
Fri, Jul 30, 1:12 PM ET, by Bob McTeer
The attention paid to the recent statements by St. Louis Fed President Bullard regarding potential deflation and a possible need for "quantitative easing" by the Fed raises some issues neglected recently. Worries about deflation We should remember that the last deflation scare, especially on the part of Chairman Greenspan, along with a weak economy, low to no job growth, and a potential double-dip recession, led to the easy-money period during much of 2002-2004. I participated in that policy, agreed with it, and even dissented favor of easing in September 2002. The policy was successful in stimulating growth, job creation, and avoiding possible deflation. However, during the recent financial crisis, the motives for and benefits of that policy were ignored. Instead, the policy was blamed for contributing to the real-estate bubble that eventually burst—triggered by the subprime crisis. My opinion is that while easy money during that period may have help fuel the housing boom and bubble, the proximate cause or trigger of the crisis was the large quantity of securitized subprime mortgage loans that began to re-set to higher mortgage rates and led to massive foreclosures. I can see how low nominal interest rates would fuel the housing boom; what I can't see is how they were responsible for subprime lending and securitization that bordered on fraud. I mention this experience just as a reminder that dealing with a real or imagined deflation is tricky business, doomed, if not to fail, at least to be judged a failure. Remember, successful policy usually means nothing happens (no deflation) while any unintended consequences of that policy receives all the attention. Quantitative Easing This is an unfortunate term that connotes extreme measures and "printing money" that scares people and drives down stock prices. In reality, all it boils down to is Fed purchases of securities to expand bank lending and investing and get the money supply growing faster. This is conventional monetary policy that should be treated more routinely. Often, the distinction is made that quantitative easing implies the purchase of longer-term Treasury bonds rather than short term Treasury bills. This is a distinction without much difference in the current context. The conventional wisdom is that Fed monetary policy has been extremely easy, there is a great potential for an acceleration in inflation already baked in the cake, and a return to quantitative easing would be a drastic step. The truth is that, except for low short-term interest rates, monetary policy has not been easy for quite a while. Most of the expansion in the Fed's balance sheet and rapid money-supply growth took place at the peak of the financial crisis in the fall of 2008. The balance sheet remains large, and the bank reserves created remain. However, they are primarily on the banks' and the Fed's balance sheet as excess reserves. Those reserves bloat the monetary base (reserves plus currency outside the banking system), but they have not been used for money-creating bank lending and investing. The conventional measures of money, M1 and M2, have been growing only slowly for quite a while. This prolonged and probably inadvertent monetary tightness is showing up in both the consumer and producer price indexes. The headline number for the CPI, for example, has been negative for the past three months. The explosion of money growth in the past two years is a myth and the resulting explosion of inflation is nowhere to be found. While I don't worry much about imminent deflation, I do think that is more likely than a breakout of inflation. Is this a big deal? While I think deflation is more likely in the coming year or two than a significant pick-up in inflation, this is something the Fed should be dealing with in the normal course of business without much fanfare. The remedy is normal, routine open market purchases of whatever. To exaggerate by calling for "quantitative easing" or "printing money" given our recent experience is to cause undue alarm. Don't run the movie backwards We continue to hear calls for the Fed to "shrink its balance sheet" back to normal, primarily by selling its mortgage-backed securities. In my opinion, the current size of the Fed's balance sheet is not a problem. In fact, it helps shrink the budget deficit because of its greater earnings turned over to the Treasury. While the FOMC no doubt would like to substitute traditional government securities for the mortgage-backed securities on its balance sheet, which has to be done without a significant shrinkage of total assets (and liabilities). Otherwise, bank reserves and the money supply would shrink at a time with the economic recovery is very fragile. What is important is not the size of the balance sheet, but a change in its size. Aren't the excess bank reserves inflationary? Potentially yes, but currently no. Even though banks are earning a meager 25 basis points on their reserves, that is not sufficient incentive to keep large quantities of excess reserves uninvested or unloaned. As they were in the mid-1930s, massive excess reserves are the result of banker fear and uncertainty. The banking system has been saved, but it hasn't been made whole yet. Bankers continue to worry about reserve levels and liquidity levels and capital levels. They are willing to lend, but only very conservatively to credit-worthy borrowers. Also, much of the slowdown in bank lending comes from low demand for loans by highly qualified borrowers. The idea that the excess reserves held on banks' balance sheets should be "mopped up" to prevent them being used in inflationary ways later is a very dangerous idea. They are there voluntarily because bankers feel they are needed. To remove them would cause further bank retrenchment, as it did in the 1930s when the Fed decided to "mop up" the excess reserves of that time. As the economy and confidence improves, banks will begin using their excess reserves more aggressively. At that point, the Fed will have to be very careful not to stifle that desirable activity on the one hand or let it get out of hand and become inflationary on the other hand. Since they have lots of good, two-handed economists, I think they can pull it off. Stop the bank bashing One more thing: banks are unlikely to stop hunkering down as long as the Administration and Congress are bashing them for political purposes. This is not rocket science. You don't keep bashing over the head the goose you are counting on to lay the golden eggs. There are about 8,000 banks out there that had nothing to do with causing the financial crisis. They were victims; not villains. 
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