September 6th, 2012 | By Nick Sargen
The crux of Chairman Bernanke’s argument is that unemployment is unacceptably high at 8.3%, while inflation at 2% is within the Fed’s tolerance band. In these circumstances, he argues that the benefits of additional policy easing outweigh the potential costs. Regarding the benefits of such policies, Bernanke reported the results of Federal Reserve studies, which show that large scale asset purchases have significantly lowered long-term treasury yields, boosted output by almost 3% and increased private payrolls by more than 2 million jobs.
Bernanke also discussed four potential costs of unorthodox policies:
Weighing these considerations, Bernanke acknowledged that the use of nontraditional policies involve costs beyond those generally associated with more conventional policies; consequently the bar for using them is higher than for traditional policies. However, he comes down on the side of applying unorthodox policies in current circumstances for the following reason:
“As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.”
A recent paper by William White entitled “Ultra Easy Monetary Policy and the Law of Unintended Consequences” (August 2012), provides an interesting contrast to Bernanke’s views, as it argues that the potential costs of ultra low monetary policies outweigh the benefits. White is a distinguished economist, who wrote several influential papers at the Bank of International Settlements (BIS) that criticized central banks for ignoring the impact of “asset price inflation” stemming from rapid credit creation.
White notes that policies that central banks have followed since the financial crisis reflect a Keynesean orientation, in which policy easing is justified to restore aggregate demand after a sharp economic downturn. However, he contends the effectiveness of such policies is limited as interest rates approach zero. At the same time, he points out that the Austrian school of thought warns that credit driven expansions eventually lead to a costly misallocation of real resources, which are referred to as “malinvestments.”
Researchers at the BIS, in turn, have suggested that a broader spectrum of credit “imbalances”, financial as well as real, could lead to boom-bust cycles that might threaten both price stability and financial stability. Since the mid 1980s, for example, the Fed and other central banks sought either to prevent downturns (after the stock market crash in October 1987) or to limit them (e.g., in 1991, 2001, and 2008). However, the respective policy easing ultimately contributed to a worldwide property boom in the late 1980s, a financial crisis in Asia in 1997-98, and subsequent bubbles in technology and real estate. White observes: “By mitigating the purging of malinvestments in successive cycles, monetary easing thus raised the likelihood of an eventual downturn that would be much more severe than a normal one.”
One of the primary side effects of ultra low interest rates is on the financial sector. On the demand side, below-market interest rates can foster excessive borrowing that results in low returns, while on the supply side, it encourages imprudent lending. White contends that easy monetary conditions in the prior two decades encouraged the development of a “shadow banking system” that is based on collateral lending rather than on traditional banking relationships. He believes that low interest rates in 2003-07 made the financial sector more pro-cyclical. During the ensuing downturn, for example, financial institutions were forced to de-lever portfolios at a faster rate than in a more traditional banking system as the value of their collateral plummeted and funding in the inter-bank market halted.
In addition to commercial banks, other financial institutions have felt the unintended consequences of ultra low interest rates. They include money market mutual funds, whose viability is now a concern, and insurance companies, who are experiencing significant declines in book yields and interest spreads.
Low interest rates also carry adverse consequences for central banks. White points out central banks are now so actively involved in the interbank market and markets for government and agency securities that they effectively operate as “market makers of last resort.” As such, central banks now play a critical role in the overall allocation of credit, and these actions may pose a threat to their independence in pursuing price stability. Thus, as economic agents accumulate more debt at low interest rates, central banks may hesitate to raise short rates, because such action could cause bond yields to spike. For their part, governments may regard low rates as lessening the need to worry about outsized budget deficits.
White concludes the paper with a more desirable course of action: “What central banks have done is to buy time to allow governments to follow policies that are more likely to lead to a resumption of ‘strong, sustainable and balanced’ global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.”
My own take on this issue has changed over time. Following the collapse of Lehman Brothers, I supported the Fed’s actions to expand its balance sheet through long-term asset purchases, because it was vital to stabilize the financial system: Lending in the inter-bank market had plummeted, banks had cut back on credit availability, and the U.S. and global economy were in free fall. Consequently, it was imperative for the Fed and other central banks to act as lender of last resort.
As the financial system and economy stabilized, however, the Fed engaged in additional quantitative easing and “Operation Twist” even though interest rates were negative in real terms and banks were holding substantial excess reserves. In these circumstances, the transmission mechanism for monetary policy works primarily though financial markets, as the Fed encouraged investors to take on added risks. In this regard, it is interesting to note that the Fed is willing to take credit for lower bond yields and higher stock prices today, whereas in 2003-2007 it absolved itself of any blame for the boom in housing prices and narrowing in credit spreads.
Consequently, I am not convinced that additional policy easing will do much to bolster the economy or to lower unemployment, whereas the risk over time is that it will create distortions in financial markets that could backfire at some point. To be clear, I do not foresee an imminent threat of higher inflation, but the longer interest rates stay unusually low, the greater the threat to the financial system when rates need to be raised.