Feature
SATURDAY, SEPTEMBER 10, 2011
QE3 Could Help Get the U.S. Back on Track
By JONATHAN R. LAING
The Federal Reserve needs to take dramatic action to stave off a second round of economic decline. Why the skeptics are wrong about quantitative easing.
The Federal Reserve will have to opt for a massive new round of government-debt buying shortly as the best way to lower interest rates, boost corporate and investor spirits and revive flagging economic growth.
One of several possible stimulus choices discussed by analysts and bankers last week, this package won't exactly mimic the two rounds of quantitative easing that the Fed has unleashed over the past 2½ years, though the central bank will again be purchasing hundreds of billions of dollars of government debt. The probable alternative will be to sell short-maturity U.S. Treasuries and use the proceeds to buy longer-term issues. This strategy, nicknamed the Fed's "Operation Twist" back in the 1960s, avoids adding to its already huge balance, but could be an effective means of re-energizing the economy. The new campaign could be announced, or at least strongly hinted at, at the highly anticipated Federal Reserve Open Market Committee meeting Sept. 20 and 21.
Some easing has seemed probable and necessary following the Federal Reserve's downbeat conclave this August in Jackson Hole, Wyo. In a much-reported speech, Fed Chairman Ben Bernanke bemoaned the paralysis of U.S. fiscal policy in the wake of the bruising political battle in Washington over the U.S. debt ceiling. Christine Lagarde, new chief of the International Monetary Fund, hectored policy makers in both the U.S. and Europe over their dithering and fatal reliance on austerity measures in the face of severe debt crises on both continents.
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CloseJoshua Roberts/Bloomberg News
Looming over the week's proceedings like Banquo's ghost was a non-attendee, Vincent Reinhart, former director of the powerful Federal Reserve monetary-affairs division. The year before, he and his wife, economist Carmen Reinhart, had electrified the crowd with a paper provocatively titled "After the Fall," describing the tepid, slow recoveries that 15 other nations had endured in the post-World War II era after severe financial crises like the one the U.S. suffered. In 10 of the 15 recoveries, jobless rates did not return to pre-crisis levels for an entire decade. Likewise, growth in real gross domestic product for the unfortunate 15 lagged behind the previous decade's growth by some 1.5 percentage points annually for 10 years.
The Reinharts' history lesson has seemed like an accurate predictor to date. The news for the U.S. economy has gotten only worse in recent months despite the Fed's second bout of quantitative easing, QE2, begun last fall and extending through June. In that program, the central bank bought $600 billion of U.S. government securities for its own portfolio. Yet, first-half U.S. GDP growth came in at a tepid 0.7%. Two weeks ago, the financial markets were shocked by the August jobs report, which showed zero employment growth. Fed and private estimates of second-half 2011 and 2012 GDP growth have been dropping steadily.
In a chat with Barron's last week, Vincent Reinhart said the chances of a double-dip recession are growing. That, he points out, was the fate of seven of the 15 countries he studied. And so far the U.S. has fared worse in the five years since asset values peaked in 2006 than the median performance of the 15 nations in his report over a similar time span. The median for those 15 saw real GDP per capita rise 3.7%, while the U.S. reading fell 2.2%. Real equity prices were up 4.6% for the median, but down 15.6% for the U.S. And U.S. real home prices fell 37.9%, against the median's drop of 26.8% (see table).
Look Out Below
15 Worst Five Years* United States
After Assets Peaked Since 2006
Real GDP per Capita 3.7% -2.2%
Real Equity Prices 4.6 -15.6
Real Home Prices -26.8 -37.9
Source: Carmen M. Reinhart, "After the Fall," in Macroeconomic Challenges: The Decade Ahead (Jackson Hole, Wyo., Federal Reserve Bank of Kansas City, 2010).
*Median
With that backdrop, the stakes couldn't be higher when the Fed meets again next week. The meeting was extended from one day to two because there's so much to discuss.
WHETHER IT ACTS IMMEDIATELY or waits a bit longer, the Fed has some maneuvering room to take aggressive action to kick-start the economy. Inflation, the central bank's primary bugaboo, may be starting to recede from the core rate of around 2% that is the Fed's upward boundary. President Obama's new $447 billion growth program notwithstanding, the Fed is the only reliable game in town these days for economic stimulus. The budget deficit wars in Washington have all but neutered the possibility of fiscal stimulus from enhanced government spending.
It will take all of Bernanke's powers of persuasion to get the Open Market committee to approve a policy akin to the last two quantitative-easing programs. In all, the Fed bought nearly $2 trillion of mortgage-backed securities and U.S. government debt and more than tripled the size of its balance sheet to $2.85 trillion, prompting fears of incipient inflation. At the Aug. 9 Fed policy meeting, three regional bank presidents broke ranks with Bernanke over keeping the Fed's key short-term interest rate near zero for at least the next two years. And that announcement was far less controversial than the accommodation now contemplated.
One compromise strategy that's been discussed would be for the Fed to lower or completely eliminate the 0.25% rate that it pays banks for parking some $1.6 trillion of excess reserves at the central bank. Most of these reserves were generated by the Fed's own debt purchases in its quantitative easing. But rather than extending additional credit via business and consumer loans, the banks have largely bucketed the money back to the Fed, earning an interest rate higher than that paid on two-year government debt.
"By lowering or eliminating the rate on excess reserves, banks would at least be forced to invest in government debt or corporate commercial paper even if they refuse to make more loans," says Alan Blinder, the Princeton economist who was a vice chairman of the central bank during the Clinton administration. "This is by no means a major weapon in reviving the economy, but the move would be marginally helpful."
Quantitative easing is a major weapon that's potentially more effective. The difficulty is the controversy the tactic -- especially QE2 -- has engendered. Inflation hawks contend that by in effect printing money to make the securities purchases, the Fed ends up fanning inflation. Van Hoisington, who runs the government-bond investment boutique Hoisington Investment Management, points out that both QE1 (late 2008 to March 2010) and QE2 (November 2010 to June 2011) failed in the ostensible purpose of lowering Treasury yields. The 10-year note, for example, rose from 3.1% to 3.8% during the first easing and from 2.7% to 3.2% in the second. The U.S. economy also lost steam during QE2.
The Bottom Line
The U.S. economy is doing worse than most countries that suffered a major financial crisis. That means the Federal Reserve should respond with a new quantitative-easing program.
But skeptics of quantitative easing may be missing several subtle yet salient points. Commodity prices soared during QE2 because of external -- in economist patois, exogenous -- factors like the Arab Spring and interrupted oil shipments from Libya, not from the size of the Fed balance sheet. Surely the impact of supply-chain interruptions caused by the Japanese tsunami and the European financial crisis trumped QE2's positive effects.
The importance of quantitative easing is that by making massive buys of securities like Treasuries, the Fed nudges the sellers into investing in riskier asset classes like corporate bonds and stocks, which in turn bolsters business and consumer confidence. As a result of this investor displacement, it's no accident that stock prices have soared and corporate yield spreads to Treasuries have plummeted during both previous periods of easing.
Worries about expanding the Fed's balance sheet make an exact replica of the first two easing programs virtually impossible. That makes the "twist" the best tool to reverse the U.S.'s economic slowdown. It is self-funding to the extent that the sales of short-term government debt match the purchases of 10- to 30-year Treasuries. Long government bond rates already have begun to fall in anticipation of the move, but corporate bond and mortgage rates should also drop, helping businesses and consumers.
This promises to be Bernanke's Last Stand. To avoid Custer's fate, the Fed must use all of its substantial weapons.
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