Tuesday, June 5, 2012

No More Quantitative Easing Please!

We wrote several years ago about this Federal Reserve Chair politicizing the Fed and putting it at the electoral service of two administrations.  We have heard about Bernanke "learning" from the inaction of Japanese monetary authorities during their crisis, resulting in their long comatose economy.  Well, this Fed has taken the approach of always doing something, viz. QE, QE2, Operation Twist, perhaps Operation Twist and Shout. Doing too much and giving too much of the wrong policy medicine is just as foolish as doing less, perhaps more so.  It really needs to stop, as several of the more sensible Fed Presidents like Fisher and Kocherlakota have been saying for two years.

I found an interesting paper by Pietro Catte et al. of Banca d'Italia contained in a book called "Monetary Policy After the Crisis," published by The European Money and Finance Forum. The reason I start here is that it examines the question of what might have happened had the Fed not pursued its secular low interest policy in the long run up to the financial crisis.  For those macroeconomic model geeks out there, the model used is a variant of the one the IMF has used for policy simulations, and it has credibility as well as some obvious limitations.  However, quibbling about model specification doesn't, I believe, change the basic conclusion of Catte's paper.

The authors simulate a different U.S. monetary policy from 2003Q1 to 2005Q2, which is a fulcrum for the 2002-2007 run up to the global crisis.  The Fed during this period increases the target Fed Funds rate from 1.5% to 3.75% in 2005Q2, maintained at that level for two quarters, following a Taylor Rule thereafter.The overall interest rate path follows a Taylor Rule policy guideline.  At the same time China does not pursue its mercantilist policy, but rather stimulates domestic demand and lets the renmimbi appreciate significantly.  Japan and Germany, in Catte's "counterfactual" simulation, also stimulate domestic consumption.  The simulation is really a global demand rebalancing, something which Paul De Grauwe is currently advocating within the European Union. 

The global demand shock ticks up the inflation rate in the short term.  Long-term bond premia increase. In the U.S. the simulation posits increases in U.S. mortgage rates.  The choice of the interest rate path in the model is chosen to put 2002-2007 rates at their 1990's average levels.  In the simulation, at year-end 2006, U.S. home prices in real terms are 8% lower than baseline.  The overall inrease in home prices from 2001-2006Q4 is cut by 11% in the counterfactual simulation. 

Since the simulation doesn't contain a discrete banking sector model, the authors have to assume that U.S. policy makers didn't explicity allow or encourage lax underwriting standards or give up on supervision of banks and thrifts, as they did with IndyMac. 

The punch line of this simulation?  The loss in U.S. GDP from the peak to the cycle trough is 3% of GDP versus an actual 6% of GDP.  A pretty significant difference! Continuing the current low interest rate environment through another QE does nothing to address the persistent imbalances among national output, consumption and export levels. 

Monetary policy is absolutely the wrong tool to manage macroeconomic imbalances, more properly the realm of fiscal policy.  Forcing a rigid fiscal austerity on the weak sisters in the European periphery while the stronger countries stand holding their breath with arms folded, is not the right answer. 

First things first.  No QE3.  No Operation Twist and Shout. No more monetary "Shock and Awe."  Lowering rates further or keeping them low indefinitely will NOT raise the "animal spirits" of entrepreneurs and megacap corporate CEOs.  Why?  If there's no reasonable prospect for increased final demand in the foreseeable future, businesses will sit on their cash because the capacity increasing projects still won't be worthwhile even if rates decline by a further 30 bp.  They will instead pursue mega mergers and short-term measures to raise their share prices. Larry Summers makes this point in more colorful language than I can conjure up.

Fiscal policy should be aimed at nudging, cajoling, and jawboning industry to build more piplines to move North America's inreasing energy resources to where consumers need products, building LNG terminals for export, building more refineries, swtiching coal plants to gas, and building out the power grid and telecom infrastructure, to name a few.  We have to get rid of the budget-busting social initiatives currently in place in order to accomodate a change in the expenditure mix. 

Investing in what we need to become productive in the future would be a desirable by-product of this persistent low-rate environment.  Its blind perpetuation would be a continuing transfer of wealth to financiers and speculators.

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