Is That All There Is? The Remarkably Small Costs of Quantitative Easing
Let's break out the booze and have a ball if that's all there is.
– From the song "Is That All There Is?" by Jerry Leiber and Mike Stoller
At Jackson Hole last week, Federal Reserve Chairman Ben Bernanke provided more detail on the "costs and risks" he had cited in his June Federal Open Market Committee (FOMC) press conference as the main reasons why the Fed has been slow to use more quantitative easing to fix the economy. But the details make it clear that these costs are very small indeed, even if Bernanke was not inclined to admit it. Bernanke did acknowledge that there have been enormous costs from the unusually weak recovery—costs that would have been reduced by more aggressive quantitative easing. The Fed will almost surely announce further actions at its policy meeting next week, but I am concerned that an inappropriate balancing of the costs and benefits is likely to cause the Fed to err on the side of doing too little.
The first cost of quantitative easing cited by Bernanke is that the Fed could become the dominant buyer and holder of long-term Treasury and agency securities. According to Bernanke at Jackson Hole, "trading among private agents could dry up, degrading liquidity and price discovery … [and] impede the transmission of monetary policy. For example, market disruptions could lead to higher liquidity premiums on Treasury securities, which would run counter to the policy goal of reducing Treasury yields."
But the Fed could address this problem by announcing adjustable daily targets for the yields of the securities it is buying. To hit these targets it would accelerate or decelerate its rate of purchase within the day. That would give market participants some assurance about the price for which they could buy and sell Treasury securities at any time, which is the operational definition of a liquid market. More broadly, one of the main purposes of quantitative easing is to force investors out of the market being targeted and into other markets, which would become more liquid. The Treasury yield curve can still provide a market benchmark even if private investors have most of their portfolios in other markets.
The second of Bernanke's costs of quantitative easing is that the public might believe that it will be difficult for the Fed to tighten policy at the right time to prevent excessive inflation in the future. This fear might increase uncertainty and instability in markets. But so far there is not a shred of evidence to support this cost. No one I have spoken to at the Fed is concerned about the Fed's ability to fight inflation in the future. The key to preventing this cost from materializing is constant communication about the Fed's intentions. Experience shows that inflation fears are highly sensitive to strong policy actions (or the lack thereof) in response to observed inflation. Thus the Fed needs to calibrate its policy stance visibly in response to deviations of both unemployment and inflation from their previously projected levels. As discussed below, targeting a path for nominal GDP that is consistent with low inflation may be a good way to provide stimulus in the short run and clarity about the Fed's intentions over the long run.
The third cost is that low long-term yields may encourage risky behavior that threatens financial stability. Bernanke claims to see little evidence of such behavior and he points to new financial supervisory tools designed to prevent it. Moreover, a monetary boost to economic recovery would reduce risks to financial stability by improving profits and decreasing the number of bankruptcies. Bernanke all but admits that this cost is immaterial. Some observers have argued that we are already seeing a risky bubble in the bond market. But low long-term yields are not a bubble when they are intentionally engineered by monetary policy. It is unlikely that systemically important institutions are holding excessive long positions in bonds, and it is the job of the Financial Stability Oversight Council, newly established by the Dodd-Frank Act, to prevent such behavior.
The fourth cost is the possibility that the Fed could incur financial losses on its enlarged balance sheet. Bernanke simply dismisses this cost altogether when it is viewed in the overall context of the national balance sheet. To date the Fed has earned extraordinary profits from quantitative easing. The Treasury also has gained both from lower borrowing costs and from higher tax revenues. The Treasury's gains far exceed any possible losses to the Fed. And private citizens receive further benefits to the extent that quantitative easing has boosted employment.
All of the above costs combined are far smaller than the benefits from aggressive monetary easing. Next week the Fed should promise to hold the prime mortgage rate below 3 percent for at least 12 months. It can do this by unlimited purchases of agency mortgage-backed securities. By giving people a fixed time period to take advantage of the lowest mortgage rates in history, the Fed could meaningfully boost the housing market just when buyers are beginning to believe that prices are starting to head up. The Administration could capitalize on this opportunity by forcing the housing agencies and jawboning the banks to stop applying excessively high credit standards for prime mortgages.
To maximize the potential benefits of sound monetary policy, the Fed should seriously consider the proposals of Christina Romer and Michael Woodford to target a fixed path of nominal GDP, the broadest measure of economic activity in dollar terms. The path should be based on a year of normal conditions, such as 2007, and should increase at a rate of 4.5 percent, which would allow for average growth of 2.5 percent and average inflation of 2 percent. Because we are far below such a path right now, it would take a few years of growth above 2.5 percent and/or inflation above 2 percent to return to normal. This policy would allay market fears of premature Fed tightening while being consistent with the Fed's stated long-run inflation goal of 2 percent.