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More dissent in the ranks!This time it’s from Fed Governor Kevin Warsh, who argues that monetary policy can’t fix the economy and that we’re already seeing signs of QE backfiring.
Here’s part of his speech:
The Federal Reserve is not a repair shop for broken fiscal, trade, or regulatory policies. Given what ails us, additional monetary policy measures are, at best, poor substitutes for more powerful pro-growth policies. The Fed can lose its hard-earned credibility–and monetary policy can lose its considerable sway–if its policies overpromise or underdeliver. We should be leery of drawing inapt lessons from the crisis to the current policy conjuncture. Lender-of-last-resort authority cannot readily be converted into fighter-of-first resort power.
Monetary policy can surely have great influence–most notably by establishing stable prices and appropriate financial conditions–on the real economy. By my way of thinking, the risk-reward ratio for Fed action peaks in times of crisis when it has a full toolbox and markets are functioning poorly. But when non-traditional tools are needed to loosen policy and markets are functioning more or less normally–even with output and employment below trend–the risk-reward ratio for policy action is decidedly less favourable. In my view, these risks increase with the size of the Federal Reserve’s balance sheet. As a result, we cannot and should not be as aggressive as conventional policy rules–cultivated in more benign environments–might judge appropriate.
Last week, my colleagues and I on the Federal Open Market Committee (FOMC) engaged in this debate. The FOMC announced its intent to expand the Fed’s balance sheet by purchasing an additional $75 billion of long-term Treasury securities per month through the second quarter of 2011. The FOMC did not make an unconditional or open-ended commitment. And I consider the FOMC’s action as necessarily limited, circumscribed, and subject to regular review. Policies should be altered if certain objectives are satisfied, purported benefits disappoint, or potential risks threaten to materialise.
The goals of the Federal Reserve’s policies are to promote economic recovery and to help ensure price stability, consistent with our mandate. I am less optimistic than some that additional asset purchases will have significant, durable benefits for the real economy. Of course, benefits may well be more substantial than I anticipate. Lower risk-free rates and higher equity prices–if sustained–could strengthen household and business balance sheets, and raise confidence in the strength of the economy. Modestly higher rates of inflation could increase nominal growth, and ostensibly place the economy on a stronger trajectory.
But, expanding the Fed’s balance sheet is not a free option. There are significant risks that bear careful monitoring by the FOMC. If the recent weakness in the dollar, run-up in commodity prices, and other forward-looking indicators are sustained and passed along into final prices, the Fed’s price stability objective might no longer be a compelling policy rationale. In such a case–even with the unemployment rate still high–the FOMC would have cause to consider the path of policy. This is truer still if inflation expectations increase materially. And if the Fed’s holdings work predominantly through the so-called portfolio balance channel, the cessation of purchases should not reverse any benefits attained.
The Fed’s increased presence in the market for long-term Treasury securities also poses nontrivial risks. The Treasury market is special. It plays a unique role in the global financial system. It is a corollary to the dollar’s role as the world’s reserve currency. The prices assigned to Treasury securities–the risk-free rate–are the foundation from which the price of virtually every asset in the world is calculated. As the Fed’s balance sheet expands, it becomes more of a price maker than a price taker in the Treasury market. And if market participants come to doubt these prices–or their reliance on these prices proves fleeting–risk premiums across asset classes and geographies could move unexpectedly. The shock that hit the financial markets in 2008 upon the imminent failures of Fannie Mae and Freddie Mac gives some indication of the harm that can be done when assets perceived to be relatively riskless turn out not to be.
In the United States, the Fed’s expanded participation in the long-term Treasury market also runs the more subtle risk of obfuscating price signals about total U.S. indebtedness. Long-term economic growth necessitates putting the U.S. fiscal trajectory on a sounder footing. The fiscal authorities need as clear an early warning system as possible, not a handy excuse to delay.
And overseas–as a consequence of more-expansive U.S. monetary policy and distortions in the international monetary system–we see an increasing tendency by policymakers to intervene in currency markets, administer unilateral measures, institute ad hoc capital controls, and resort to protectionist policies. Extraordinary measures tend to beget extraordinary countermeasures. Second-order effects can have first-order consequences. Heightened tensions in currency and capital markets could result in a more protracted and difficult global recovery. These, too, are developments that the FOMC must monitor carefully.
Responsible monetary policy in the current environment requires attention not only to near-term macroeconomic conditions, but also to corollary risks with long-term effects. Should these risks threaten to materialise, however one gauges the probabilities, I am confident that members of the FOMC will have the tools and convictions to adjust policies appropriately.