Explain Yourself, Ben Bernankeby
One day soon, perhaps at its meeting this week, the Federal Reserve will decide to curtail monthly bond purchases aimed at reviving the U.S. economy. When it does, it had better be careful with the message it sends to markets.
The bond-buying program, known as quantitative easing, has taken the Fed deep into uncharted territory. Over the past year, the central bank has added more than $1 trillion, at a rate of $85 billion a month, to what was already a record-large balance sheet. The purchases have helped prop up stocks and the housing market by keeping long-term interest rates low. The economy needed this extra stimulus: The slow recovery would have been even slower without it.
Right from the start, though, QE had drawbacks, and these have been growing. The Fed already owns about a fifth of all Treasury bonds and agency-insured mortgage securities outstanding. Such large holdings can hinder the functioning of markets, by restricting the supply of low-risk securities that investors need for purposes such as posting collateral on loans and derivative contracts. Also, the larger the holdings become, the greater the risk that the central bank will suffer losses.
The balance of these costs and benefits is gradually turning. The economy is showing tentative signs of faster growth, and the efficacy of further QE may be waning. Before much longer it will make sense to slow the pace of the program. The Fed would be wise to hold off a little while yet -- inflation is still well below the Fed’s 2 percent target, and the share of the population with a job is still close to its lowest point in 30 years. Even so, it’s only a matter of time.
Explaining the decision to taper once it’s made may be more important than choosing exactly when. The Fed’s rationale matters a lot because investors have come to see the bond-buying program as an indicator of monetary policy as a whole. Statements on quantitative easing have invariably affected investors’ expectations about what the central bank intends on short-term interest rates, despite the Fed’s strenuous efforts, heavy on automotive and nautical metaphors, to keep the two separate.
If the Fed starts to taper because of concerns over financial stability rather than because it has grown more optimistic about the pace of recovery, it had better make that crystal clear. Otherwise the markets will bring forward their expectations for higher interest rates and tighten monetary conditions in a way the Fed doesn’t intend. The best way to provide that clarity is to be straightforward: Explain why the risks of quantitative easing have come to outweigh the benefits, and underline that interest rates will stay very low until rising inflation becomes a concern.
It would be possible to go further -- for example, by promising to keep interest rates low for a fixed period come what may, or by changing the unemployment and inflation targets to signal that stimulus will be maintained for longer than investors currently expect. Another option which the Fed appears to be considering would be to cut the interest rate paid on banks’ reserves at the Fed to zero, or perhaps levy a charge. The idea is to encourage banks to run down their excess reserves and lend more. This last proposal looks especially appealing.
Whatever the mechanism, the message must be clear. If the Fed thinks it’s too soon to withdraw stimulus, it mustn’t let a decision to taper (made on financial-stability grounds) be heard as announcing the opposite. Keep it simple, and enough with the metaphors already.
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