Further Fed Easing Addresses the Wrong Problem

Photograph by Andrew Harrer/Bloomberg

Barring some kind of unforeseen surge in the economy, the Fed will “likely” embark on additional stimulus. That’s not really news. We already knew the Fed had inched closer to action from the statement it released following its July 31-Aug. 1 Open Market Committee meeting. The minutes (PDF) released on Aug. 22 only reinforce that view.

The key difference is that the bar has been lowered. The economy doesn’t have to get worse to compel the Fed to act, it now has to show “substantial and sustainable improvement” in order for it not to act. We can assume that means growth higher than the 1.5 percent pace tallied in the second quarter.

The Fed will likely want to see how many jobs the U.S. generated in August before announcing any further action. Tom Porcelli, chief U.S. economist at RBC Capital Markets, thinks the timing of more easing hinges entirely on the jobs report due out Sept. 7. ”If you see another 150,000 or more jobs added, that buys them some time,” says Porcelli. “If it’s 100,000 or below, I think they will consider teeing up QE3 for September.”

Now that a majority of FOMC members appear ready to throw the gauntlet down, the question is what will they do with it? The conventional wisdom is we’ll see a third round of bond buying, or quantitative easing, the so-called QE3. But what kind of bonds? Treasuries? Mortgages? Near-term? Longer-dated? A little bit of both? That’s anyone guess.

Four years into this unprecedented period of monetary stimulus, and on the precipice of more, two questions are worth asking: Is it working? And is it risky?

The answer to both seems to be, not really. Now that the Fed has expanded its balance sheet to about $2.8 trillion, from about $900 billion in August 2008, the strategy appears to be suffering from the law of diminishing returns. The more you do something, the less effective it becomes over time. Not only that, but monetary easing isn’t really a good solution to what’s wrong with the economy. U.S. economic growth is anemic because demand is low. And demand is low because a) growth has consistently been weak, and b) we’re still working our way out of a huge credit boom.

“It’s hard to stimulate demand with low interest rates when low interest rates aren’t the problem,” says David Rosenberg, chief economist at Gluskin Sheff & Associates. Consider this: For the first time ever, household net worth has contracted over a five-year period, as Rosenberg pointed out in a note this week to clients. The remedy to that problem isn’t lower rates.

Lacking any fiscal action from Congress, Ben Bernanke has been left with no choice but to do something—anything. The risk of all this easy money sloshing around the economy is that it creates inflation. That’s the theory, at least. So far it hasn’t happened. The Fed may be printing money, but no one’s doing anything with it. Just look at the banks. The gap between deposits and lending is now a record $1.77 trillion. The capital the banks are deploying is being ploughed back into the U.S. Treasury market. Banks have already bought double the amount of Treasuries they did in 2011, pushing their holdings to an all-time high of $1.84 trillion.

“Let’s say you bake a cake, but no one eats it,” says Neil Dutta, head U.S. economist at Renaissance Macro Research. “It’s the same thing with the Fed.”

Assuming that at some point the economy returns to a more normal state, the Fed will need to unwind itself. That process will consist of two things: raising the fed funds rate and selling off a lot of the securities on the Fed’s balance sheet. That’s a delicate process that must be handled carefully. If it acts too late, the fear is that inflation goes out of control from an overheated economy. But if it acts too soon, it risks pushing the economy off the rails.

Bernanke’s true test will be his ability to balance deftly the unwinding of this massive position he’s put on. Assuming, of course, he’s still on the job. Bernanke’s term expires in 2014. If Obama wins, you wonder whether Bernanke will still want the job, given how stressful the past five years have been. And a potential President Romney is already on record saying he would choose a new Fed chief.

That means there’s a decent chance someone else will face the job of soaking up all the easy money the Fed’s put into the system.

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