This article first appeared in the St. Louis Beacon, June 7, 2012 - The May jobs report did little to dispel the notion that the U.S. economy is in a holding pattern of tepid economic growth. The unemployment rate is a percentage point lower than a year ago, but continued decline is less certain. With Europe in its own malaise and China showing signs of slowing, calls for more expansive policy action are being sounded.
Conventional wisdom once had it that expansionary fiscal policy — especially more spending — drove recoveries. Some still hold this view. Nobel Prize laureate and New York Times columnist Paul Krugman argues that more federal spending will right the economic ship. This view ignores research showing that when larger future deficits and debt loom many of us reduce current spending. This may seem counter-intuitive, but the logic is straightforward: Future debts must be repaid and taxes will be raised to do so. With large deficits looming on the horizon, we reduce spending now to save for the inevitable tax liability.
With fiscal policy ineffective, monetary policy is viewed as the only effective lever left to pull. But what can the Fed do? And will it help?
The Fed manipulates short-term interest rates (and the supply of money) by purchasing and selling short-term government securities in the open market. In tough times the Fed buys these securities, lowering interest rates and pushing money into the economy. These dual consequences increase borrowing and spending and spurs economic activity. The aim of such a policy response is to get the economy back on its feet so market forces can once again propel the economy.
Fed policy has changed since 2008. Once it lowered short-term rates to near-zero, it needed other tools to increase economic activity. The Fed became the buyer of last resort. With its traditional policies insufficient to boost demand, it began series of quantitative easing or QE programs. Under QE, the Fed buys financial assets directly from banks and other financial institutions. In addition to its traditional portfolio of government securities, the Fed now owns hundreds of billions of dollars in, among others, mortgage-backed securities.
The Fed bought these “toxic assets” to buoy the balance sheet of banks facing significant losses as the housing market tanked. Banks unloaded risky assets and got reserves for them. This reduced banks’ risk exposure. But the quid pro quo that everyone expected was that banks would in turn create loans with these funds. Today banks are sitting on a huge mountain of reserves (for which they are paid interest by the Fed), lending remains stagnant, and the economy sputters.
The Fed also resurrected a failed policy undertaken in the 1960s. Called “operation twist” at that time, the idea is that by selling some of its short-term Treasury securities and buying long-term Treasury securities, the Fed can push long-term interest rates down. Again the idea is to lower borrowing costs for long-term projects, such as housing. It has done so. But even as long rates declined and mortgage rates have reached all-time lows, borrowing has not responded.
How will the Fed respond to the latest spate of poor economic data? We’ll get an answer when the Fed’s policy making group, the FOMC, meets later this month. But what should the Fed do? he surprising answer is nothing, because there is little it can do and make a difference.
Short-term interest rates are effectively zero. The rate on 10-year Treasuries recently hit an unprecedented level below 1.50 percent. Even if more operation twist lowers long-term rates and reduces mortgage rates by a few basis points that will not induce a significant increase in borrowing.
Fed policy should hold steady. Even in the face of weak economic data and mounting political pressure, it must not succumb to even more expansive policies. This tough choice is necessary to maintain policy credibility: The Fed must not be seen as a pawn of presidential politics. Now, if we could only find some way to increase the credibility of fiscal policy.