After the Lehman Brothers crisis, Ben Bernanke's Federal Reserve demonstrated creativity and nerve. Unfortunately, that reputation is no longer justified. Today's Fed confronts slowing growth, high unemployment and well-anchored inflation expectations. And yet it hesitates. Paradoxically, its image as a risk-taker inhibits its ability to be genuinely bold.
Back in 2008-09, the Fed took real risks with its balance sheet – risks that private actors shunned. It bought portfolios of toxic securities. It lent to manufacturers. It backstopped money-market funds. But today the Fed's supposedly audacious "unconventional policies" consist of buying Treasury securities. These are the safest possible instruments and there is no shortage of private actors lining up to buy them. Prices are screaming out this message. Interest rates on 10-year Treasuries are at a record low.
Because of Mr Bernanke's reputation for boldness, he is frequently accused of creating money wildly. When he appeared last week before Congress, he was rebuked by Republicans for his presumed recklessness, while Democrats appeared to feel he was pushing policy as far as he could. But there is nothing particularly wild about the Fed's money printing. Its purpose is merely to effect a change in private balance sheets. Banks sell their Treasuries to the Fed in exchange for newly minted dollars (in the case of quantitative easing) or for shorter-term government securities (in the case of the current Operation Twist). Given that risk-free government securities are treated as cash equivalents by financial institutions, this is not radical.
Most assessments of quantitative easing find that it has worked. In May, a paper by two Federal Reserve Board economists calculated that the Fed's asset purchases had lowered 10-year Treasury rates by 1 percentage point. Last year the San Francisco Fed estimated, a bit heroically, that output might be 3 per cent higher at the end of 2012 than it would have been otherwise. But these positive verdicts conceal a less uplifting message. The first round of quantitative easing was most powerful – it was the largest, and its novelty inspired shock and awe. The second round, from November 2010 to June 2011, was less effective. The current Operation Twist is the limpest of all.
Unless the Fed can rekindle the shock value of the first round, more quantitative easing is unlikely to work. Success depends on a whole range of actors deciding that the Fed is determined to accelerate recovery rather than repeat a tired trick that they have seen before. Banks, having sold Treasuries, must choose to reinvest the proceeds in riskier assets rather than just adding to their huge cash piles. Corporations, facing lower borrowing costs, must resolve that this is the moment to invest. Consumers, seeing rising stock and bond markets, must summon the confidence to spend. If the Fed won't take the risk of going beyond what it has tried already, private actors won't take risks either. Monetary policy is like faith healing. The patient must believe.
Quantitative easing that fails to spark risk-taking could actually make things worse. A Fed that is both active and ineffectual is the worst thing for confidence, and indefinite purchases of Treasuries threaten to upset the way markets work. As the IMF's Manmohan Singh argues, the Fed's appetite for safe assets is draining the financial system of an essential lubricant. Traders use Treasuries as downpayments on derivatives positions; investment funds use them as collateral when they borrow. Because Treasuries circulate so rapidly through the financial system, Mr Singh suggests that $1m of them in private hands will stimulate more growth than $1m of cash.
And so the Fed faces a dilemma. With inflation below target and unemployment far above the neutral rate, there is a clear case for stimulus. But the familiar tools of stimulus seem unlikely to work. So the markets expect next week's Fed policy meeting to produce more equivocation. The better way forward would be to come up with new tools.
One possible measure is to cancel interest on excess reserves. At present, the Fed pays 25 basis points to banks that deposit cash with it, a perverse reward for keeping money inert. Eliminating that incentive might steer cash into the real economy. But it would also drive cash into the money markets, where returns would soon fall to zero or lower. Money market funds would be hard-pressed to avoid breaking the buck again. Panic might follow.
That leaves a second option: the Fed could couple more quantitative easing with a formal announcement of a higher inflation target. Some Fed leaders are open to this. Charles Evans, the Chicago Fed president, has floated the idea of a 3 per cent target, effective until unemployment falls below 7 per cent. A higher inflation target would lead markets to understand the Fed is committed to quantitative easing of game-changing magnitude, inducing the behavioural shifts needed to make the policy succeed. Financiers would embrace risk assets rather than safe ones with real returns that would be clearly negative. Companies, expecting more growth, would step up investments. Consumers, seeing the real value of their debts eroding, would probably spend more.
The Bernanke Fed has been pilloried for pursuing wild quantitative easing at the risk of inflation. The truth is that it has pursued cautious quantitative easing without risking inflation. The time has come for some fresh thinking. A Fed that can escape the myth of its audacity might be able to do more.
The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor
This article appears in full on CFR.org by permission of its original publisher. It was originally available here.