Credit and the Bernanke Code

To understand the Federal Reserve's latest attempt to jump-start the U.S. economy, consider what the central bank did not say. In its Nov. 3 announcement, the Fed never used the phrase "quantitative easing" to describe its program of buying another $600 billion worth of long-term Treasury bonds between now and the middle of 2011.

The Fed weighs its words carefully, so it's no accident that Fed Chairman Ben Bernanke and fellow members of the Federal Open Market Committee have resisted the label put on the plan by economists and journalists. Bernanke in past speeches described the Fed's strategy as "credit easing," although the FOMC stuck to the bland "asset-purchase program" on Nov. 3. Whatever it's called, Bernanke thinks it has a better chance of boosting the economy than what he calls quantitative easing.

The Fed has a lot riding on the success of its bond-buying strategy, which comes on top of the nearly $1.5 trillion in assets it has added to its balance sheet since 2008. The interest rate it directly controls is already as low as it can go. More government spending might juice growth, but that's even less likely now that Republicans have won control of the House on an anti-deficit-spending platform.

What gives the Fed's plan at least a chance of success is the bank's almost magical ability to create money out of thin air. When the Fed buys a Treasury bond, it pays by simply marking up the balance in the seller's account at the Fed. It's the electronic equivalent of printing money.

Bernanke will use this unique money-creation power to scoop up lots of Treasury bonds. By increasing the demand for them, he hopes to increase their price and push down their yields. Then, if all goes according to plan, falling yields on Treasuries will induce investors to move some of their money to other fixed-income securities with higher yields, ranging from corporate bonds to securities backed by mortgages, auto loans, and student loans. Stepped-up demand for those securities would drive down their yields, too, the Fed hopes, lowering interest rates throughout the economy and stimulating growth.

All of this credit easing occurs on the asset side of the Fed's balance sheet. In contrast, Bernanke says that quantitative easing, properly understood, refers to the liability side of the balance sheet, the bottom half of the chart. Bernanke has defined quantitative easing as increasing the reserves that banks hold at the Fed so they'll have ample capacity to lend. Since banks are already sitting on $1 trillion more in reserves than they require, Bernanke doesn't think that's the right way to fight the slump.

Hang on for one more twist in the argument. Economists who describe the Fed's initiative as quantitative easing say Bernanke is making a distinction without a difference. They point out, correctly, that the Fed can't operate on just one side of the balance sheet. The only way it can buy assets (which is credit easing) is by increasing bank reserves (which is quantitative easing). But Bernanke says that credit easing is distinguished by what the Fed buys, not how much it buys. If all the Fed wanted was to give banks more reserves (i.e., quantitative easing), it could buy any asset, including short-term Treasury bills, whose yields are already below 0.2 percent. It's not doing that. It's buying mostly securities maturing in two to 10 years, the ones most private debt is benchmarked against.

So what the Fed is doing isn't quantitative easing at all by the bank's own definition. Jan Hatzius, chief U.S. economist at Goldman Sachs, says Goldman economists avoided calling it QE until about six months ago, when "we got tired of fighting an unwinnable fight."

Economists are divided over whether the asset-buying plan will work. Goldman argues that buying long-term assets can stimulate the economy if pursued on a massive scale. It estimated before the announcement that $1 trillion in asset purchases might boost the size of the economy by about 1.2 percent over two years. Morgan Stanley economists Joachim Fels and Manoj Pradhan wrote before the announcement that bond-buying should boost growth by lifting asset prices, lowering the dollar, and raising expected inflation—thus reducing the inflation-adjusted level of interest rates.

Perry Mehrling, a Barnard College economist who has written a forthcoming book on Fed policy called The New Lombard Street, is more skeptical. He says the Fed's first asset-buying program made sense because it was focused on mortgage-backed securities, for which there was scant private demand after the housing collapse. In contrast, he says, there's no lack of private demand for Treasuries, so purchases are "unlikely to have much positive effect."

A second criticism of the Fed's plan is that if the central bank succeeds in reviving the economy, market yields will rise and the value of its assets will plunge. If the Fed then chose to sell those bonds, it would incur a loss and be technically insolvent without an infusion of capital from the Treasury Dept., says Robert A. Eisenbeis, chief monetary economist at Cumberland Advisors, a Sarasota (Fla.)-based investment advisory firm. If the Fed intends to hold the bonds to maturity, though, it won't need to recognize a loss on them. Besides, Bernanke has argued, the Fed is in business to support the economy, not make profits.

The bottom line: The Fed's new foray into bond purchases has to lower long-term rates to succeed. The $600 billion is less than it has already spent.

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