March 5, 2012
The High Cost of the Fed's Cheap Money
Encouraging consumption at the expense of saving inhibits long-term economic growth.
By Andy Laperriere
During the past three years, the Federal Reserve has tripled the size of its balance sheet—in effect printing $2 trillion—something it had never done in its nearly 100-year history. The Fed has lowered short-term interest rates to zero and signaled that it will keep them at that level for years. Inflation-adjusted short-term rates, or real rates, have been in the minus 2% range during the past couple of years for the first time since the 1970s.
The unfortunate fact is, as Milton Friedman famously observed, there is no free lunch. After the Fed's loose monetary policy helped spur the boom-bust in housing, it's remarkable how little attention has been devoted to exploring the costs of Fed policy.
A few critics of quantitative easing (QE) and the zero interest rate (ZIRP) have correctly pointed out that these policies weaken the dollar and thereby reduce the purchasing power of American paychecks. They increase the risk of future inflation, obscure the true cost of the unsustainable fiscal policy the federal government is running, and transfer wealth from savers to debtors.
But QE and ZIRP also reduce long-term economic growth by punishing savers, reducing saving and investment over the long run. They encourage the misallocation of resources that at a minimum is preventing the natural rebalancing of our economy and could sow the seeds of another painful boom-bust.
One intended effect of a loose monetary policy is a weaker dollar, which can help gross domestic product by boosting exports. But a weaker dollar also raises import prices (such as oil prices) for American consumers. For the average American family, this adverse impact has likely outweighed any positive impact from QE and ZIRP.
The cost of a weaker dollar for most people is not offset by temporarily higher stock prices for two reasons. First, most Americans don't own much stock. Second, stock prices are not going to be higher 10 years from now because of the Fed's policies, so the effect is to bring forward equity returns, not increase long-term returns.
Artificially reducing Treasury yields provides a near-term benefit as federal borrowing costs are lower, but this unusually low cost of borrowing is enabling Congress and the president to run an unsustainable fiscal policy that could eventually lead to an economic calamity. Governments like Greece and Italy benefited from artificially low rates for years, and those low rates undoubtedly played a key role in those governments not confronting their serious fiscal imbalances.
Low rates have helped those who have been able to borrow or refinance their debts at lower rates, especially homeowners. But this has come at a high cost to savers. Zero rates are a major problem for any saver, but it is especially difficult for those in or near retirement. Government bonds are investments that now offer return-free risk.
The Fed is hoping the lack of return in certificates of deposit and bonds (or more accurately, negative returns, adjusted for inflation) will prompt investors to take on more risk by investing in stocks, high-yield corporate bonds and other investments. This is pushing people who have a low risk tolerance to take on more risk than may be advisable.
Moreover, QE and ZIRP are specifically designed to discourage saving and encourage people to consume more now to boost near-term gross domestic product. But saving is deferred consumption—people save to earn a return so that they may consume more in the future (say, for retirement or a major purchase).
Scores of economists have testified before Congress for decades that Americans don't save enough and that this inhibits long-term economic growth. Prosperity does not come from spending; it comes from work, saving and investment.
Defenders of QE and ZIRP would say that rather than borrowing economic growth from the future, these policies merely smooth the economic cycle and reduce the economic dislocation associated with deep recessions or weak recoveries. Of course, that was the rationale for the exceptionally low rates during the 2002-2004 period, which, like today, were specifically aimed at depressing saving and encouraging consumption. Rather than smooth the economic cycle, that strategy helped create an historic boom-bust.
Some say we must encourage higher consumption because it accounts for more than 70% of GDP, and the recovery is too fragile to risk allowing a rise in the savings rate. But the recession was officially over two years ago. For at least the past decade, monetary policy has consistently punished prudent savers.
Worse, the Fed is promising to keep these policies in place for years to come. When do we ever get to the point where we allow interest rates to return to some kind of natural equilibrium and allow the economy to gradually rebalance in a way that would boost long-term economic growth?
There is no doubt the Fed is doing what it believes is best. But in addition to the risk of inflation inherent in QE and ZIRP, which Chairman Ben Bernanke has said he is 100% confident he can prevent, Fed officials are dismissive of the notion that there are significant costs or trade-offs associated with the policy they are pursuing.
This is disconcerting. Is there really no chance, zero chance, the Fed will be late to pick up signs of inflation? What accounts for such confidence—given that the Fed dismissed criticisms from 2002-2004 that its policies would distort economic decisions and cause hard-to-predict imbalances, that it was oblivious to the housing collapse well into 2007, and that to this day many Fed officials refuse to accept that monetary policy played any role in creating the housing bubble?
During the bubble, Fed officials argued they couldn't spot bubbles in advance, but that an aggressive monetary policy response could limit the downside impact if a bubble were to burst. As it turns out, the dislocation from the housing bust and the financial crisis have been far more costly than almost anyone imagined. Shouldn't that cause policy makers inside and outside of the Fed to ask hard questions as it pursues its unprecedented campaign of quantitative easing and zero rates?
.Mr. Laperriere is a senior managing director in the Washington office of ISI Group.