Tag Archives: QE

(Revised) Can QE* Be an Effective Long Term Policy? Yes, and Here’s How.

The Fed’s decision to implement quantitative easing and other unconventional monetary policy in December 2008 sparked a blaze of heated discussion amongst economists that has been burning to this day. The questions of if and how these new measures affect economic growth have become the focus of countless blog posts and editorials, and have become an integral part of many university Econ courses. The beginning of QE tapering in December 2013 added even more fuel to the fire, but it also gave many traditional economists a sense of relief. It finally looked like there was an end in sight to these unfamiliar and controversial policies. To the dismay of these traditionalists, however, recent research by the Brookings Institution (paper #1 and paper #2) suggests that there are significant benefits of pursuing unconventional monetary policy in the long term. A recent Economist article, “Staying Unconventional,” emphasizes some of the most important results of this research and raises a provocative question: Can QE and forward guidance, or some alternate forms of these policies, be combined to create an effective long term policy?

Based on my reading of the research papers that the article cites, I am inclined to say yes. It may not be the QE policy currently being rolled back, but I can see an alternate form of such a policy (hence the * in the title) being effective in the long term. Not only does unconventional monetary policy not cause riskier financial behavior, but it also provides a substantial boost to economic growth. In this blog post, my goal is to defend the bolded argument by highlighting some of the key findings of the research papers I mentioned earlier.

1.    Unconventional Monetary Policy Does NOT Cause Financial Instability

The argument commonly used to refute long-term implementation of QE is that it encourages individuals and financial institutions to pursue riskier investments, thereby reducing financial stability. The prediction is that long periods of low interest rates incentivize investors to ‘reach for yield’ and take on more credit risk, duration risk, and/or leverage. The research by Gabriel Chodorow-Reich of Harvard University confirms this prediction but emphasizes that the story is not so cut and dry. Although the Fed’s low interest rate policy has caused financial institutions to take on some riskier investments, it has also boosted the value of these institutions’ portfolios, making them less risky and strengthening the stability of the U.S. economy. Most importantly, Chodorow-Reich’s analysis shows that the stabilizing effect of QE has been stronger than the destabilizing effect caused by ‘reaching for yield.’

Chodrow-Reich determined the magnitude of each effect by evaluating the effect of the Fed’s policies on four categories of financial institutions: life insurers, commercial banks, money market funds, and defined benefit pension funds. Together, these institutions manage $24 trillion in assets. The effects are nicely summarized in the graphic provided in the abstract of the paper:

unconventional MP_1

As Chodrow-Reich states, “In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”

If the biggest argument against long-term use of QE (investors reaching for yield) is nullified, perhaps the Fed should think twice about continuing to taper. There is, however, the problem of surprising the market with such a change in policy. A possible solution to this is to continue the taper, but then start buying a constant level of bonds again after the taper is complete. If the Fed warns the public of such a long term policy change in advance, it could dampen the volatility the move would create in the markets.

2. Unconventional Monetary Policy Boosts Immediate Economic Growth and May Have Substantial Long-Term Growth Benefits As Well

The research conducted by Joshua K. Hausman (University of Michigan) and Johannes F. Wieland (University of California, San Diego) examines the success Abenomics has had in boosting Japanese GDP and gives insight into how such unconventional monetary policy can sustain amplified GDP growth in the long term.

Named after Japanese Prime Minister Shinzo Abe, ‘Abenomics’ is the name used to refer to Japan’s current three-pronged economic stimulus policy, which consists of a combination of monetary policy expansion, fiscal stimulus, and structural reform. It is the only real and current example of long-term unconventional monetary policy, and is thus viewed by economists as an important test of its validity.

So far, Abenomics has stood up to the challenge. The Japanese stock market has risen, the exchange rate has depreciated, and Japan’s GDP has jumped by up to 1.7%. Hausman and Weiland claim that one percent of this GDP growth has been directly caused by the monetary policy shift. Furthermore, Abenomics’ effect on the Japanese money supply has been much more effective than that of previous QE policies. The below graphic from the Economist article provides a nice summary of the effects of Abenomics:

unconventional MP_2

Hausman and Weiland attribute the superior effectiveness of Abenomics to the change in inflation expectations it has caused. Japan has set a new 2 percent inflation target and because Abenomics was announced to the public as a permanent change in policy rather than a temporary measure to boost GDP, inflation expectations increased for both the short and long terms. Both short and long-term borrowing appeared cheaper as a result. This, in turn, caused borrowing to increase across the board, stimulating increased consumer spending.

One should not go all-in on Abenomics quite yet, though. Both the article and research paper emphasize that Abenomics is still in its initial stages and has yet to prove itself as an effective catalyst for long term growth. When discussing the long-run outlook of Abenomics, Haussman and Weiland assert:

The research shows that the Bank of Japan is achieving its intermediate objective of higher expected inflation, but that the inflation target itself ‘remains imperfectly credible,’ with long-run inflation expectations below 1.5 percent.  Thus the modest estimates of Abenomics’ effects reflect in part that the Bank of Japan has not yet fully convinced the public that inflation will be two percent.

If the Bank of Japan could somehow more strongly convince the public of a future two percent inflation rate (perhaps through a public announcement reinforcing its intention to pursue the policies of Abenomics), the effects could be substantial. Hausman and Weiland estimate that “the output effects of Abenomics could as much double if inflation expectations rose to the 2 percent level.

In summary, based on the results presented by Gabriel Chodorow-Reich about the positive effects of QE on financial stability, and Hausman and Weiland’s estimates of past and future Japanese output growth as a result of Abenomics, I am convinced that unconventional monetary policy can be used effectively in the long term. If the Fed can convince the public that inflation will be steady at two percent and interest rates will remain low, whilst continuing to purchase assets and pursuing fiscal stimulus, it can achieve both strong economic growth and increased financial stability.

(Revised) Fed, Raise the Inflation Target

Originally posted on March 29th

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”? In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?

Can QE* Be an Effective Long Term Policy? Yes, and Here’s How (Part 2)

The research conducted by Joshua K. Hausman (University of Michigan) and Johannes F. Wieland (University of California, San Diego) examines the success Abenomics has had in boosting Japanese GDP and gives insight into how such unconventional monetary policy can sustain amplified GDP growth in the long term.

Named after Japanese Prime Minister Shinzo Abe, ‘Abenomics’ is the name used to refer to Japan’s current three-pronged economic stimulus policy, which consists of a combination of monetary policy expansion, fiscal stimulus, and structural reform. It is the only real and current example of long-term unconventional monetary policy, and is thus viewed by economists as an important test of the policy’s validity.

So far, Abenomics has stood up to the challenge. The Japanese stock market has risen, the exchange rate has depreciated, and Japan’s GDP has jumped by up to 1.7%. Hausman and Weiland claim that one percent of this GDP growth has been directly caused by the monetary policy shift. Furthermore, Abenomics’ effect on the Japanese money supply has been much more effective than that of previous QE policies. The below graphic from the Economist article provides a nice summary of the effects of Abenomics:

unconventional MP_2

Hausman and Weiland attribute the superior effectiveness of Abenomics to the change in inflation expectations it has caused. Japan has set a new 2 percent inflation target and because Abenomics was announced to the public as a permanent change in policy rather than a temporary measure to boost GDP, inflation expectations increased for both the short and long terms. Both short and long-term borrowing appeared cheaper as a result. This, in turn, caused borrowing to increase across the board, stimulating increased consumer spending.

One should not go all-in on Abenomics quite yet, though. Both the article and research paper emphasize that Abenomics is still in its initial stages and has yet to prove itself as an effective catalyst for long term growth. When discussing the long-run outlook of Abenomics, Haussman and Weiland assert:

The research shows that the Bank of Japan is achieving its intermediate objective of higher expected inflation, but that the inflation target itself ‘remains imperfectly credible,’ with long-run inflation expectations below 1.5 percent.  Thus the modest estimates of Abenomics’ effects reflect in part that the Bank of Japan has not yet fully convinced the public that inflation will be two percent.

If the Bank of Japan could somehow more strongly convince the public of a future two percent inflation rate (perhaps through a public announcement reinforcing its intention to pursue the policies of Abenomics), the effects could be substantial. Hausman and Weiland estimate that “the output effects of Abenomics could as much double if inflation expectations rose to the 2 percent level.

In summary, based on the results presented by Gabriel Chodorow-Reich about the positive effects of QE on financial stability, and Hausman and Weiland’s estimates of past and future Japanese output growth as a result of Abenomics, I am convinced that unconventional monetary policy can be used effectively in the long term. If the Fed can convince the public that inflation will be steady at two percent and interest rates will remain low, whilst continuing to purchase assets and pursuing fiscal stimulus, it can achieve both strong economic growth and increased financial stability.

Can QE* Be an Effective Long Term Policy? Yes, and Here’s How (Part 1)

The Fed’s decision to implement quantitative easing and other unconventional monetary policy in December 2008 sparked a blaze of heated discussion amongst economists that has been burning to this day. The questions of if and how these new measures affect economic growth have become the focus of countless blog posts and editorials, and have become an integral part of many university Econ courses. The beginning of QE tapering in December 2013 added even more fuel to the fire, but it also gave many traditional economists a sense of relief. It finally looked like there was an end in sight to these unfamiliar and controversial policies. To the dismay of these traditionalists, however, recent research by the Brookings Institution (paper #1 and paper #2) suggests that there are significant benefits of pursuing unconventional monetary policy in the long term. A recent Economist article, “Staying Unconventional,” emphasizes some of the most important results of this research and raises a provocative question: Can QE, or some alternate form of it, be an effective long term policy?

Based on my reading of the research papers that the article cites, I am inclined to say yes. It may not be the QE policy currently being rolled back, but I can see an alternate form of such a policy being effective in the long term (hence the * in the title). Not only does unconventional monetary policy not cause riskier financial behavior, but it also provides a substantial boost to economic growth. In this blog post and the next one, my goal is to defend the bolded argument by highlighting some of the key findings of the research papers I mentioned earlier. The remainder of this post will be dedicated to discussing the first claim:

1.    Unconventional Monetary Policy Does NOT Cause Financial Instability

The argument commonly used to refute long-term implementation of QE is that it encourages individuals and financial institutions to pursue riskier investments, thereby reducing financial stability. The prediction is that long periods of low interest rates incentivize investors to ‘reach for yield’ and take on more credit risk, duration risk, or leverage. The research by Gabriel Chodorow-Reich of Harvard University confirms this prediction but emphasizes that the story is not so cut and dry. Although the Fed’s low interest rate policy has caused financial institutions to take on some riskier investments, it has also boosted the value of these institutions’ portfolios, making them less risky and strengthening the stability of the U.S. economy. Most importantly, Chodorow-Reich’s analysis shows that the stabilizing effect of QE has been stronger than the destabilizing effect caused by ‘reaching for yield.’

Chodrow-Reich determined the magnitude of each effect by evaluating the effect of the Fed’s policies on four categories of financial institutions: life insurers, commercial banks, money market funds, and defined benefit pension funds. Together, these institutions manage $24 trillion in assets. The effects are nicely summarized in the graphic provided in the abstract of the paper:

unconventional MP_1

As Chodrow-Reich states, “In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”

Fed fails to indicate what labor market signal will be

The Fed announced today that it will continue its tapering program, reducing purchases of long-term Treasury bonds from $35 billion per month to $20 billion per month, and cut back on its mortgage-backed securities purchases by $5 billion as well, to $25 billion. These results came as expected, with the $10 billion monthly decrease continuing each month. The bigger news was the Fed’s announcement on whether it will start to bring rates back up as the targeted 6.5% unemployment rate is due to be met in the upcoming weeks.

On Wednesday, the Wall Street Journal reported that “the Fed dropped the reference to the 6.5% jobless rate, which officials have come to see as too limited an indicator of the labor market’s health.” The proclamation of being “too limited an indicator” tells true, as unemployment rates have sunk in some part due to discouraged workers dropping out of the work force entirely after failing to find employment. However, the Fed offered little insight on what they believed better labor market indicators to be, or when they will determine that the economy has shown enough recovery. The stock market fell after the news, on the idea that rates may be rising sooner than previously expected.

The majority of Fed officials on Wednesday predicted that rates will begin to increase within the year, with 10 of 16 expecting increases to begin in 2015. The real news of the day was the ambiguity that the Fed left in its wake. Will a 6% unemployment rate be enough to spark a rate increase, or is the unemployment rate now discredited by the Fed as a worthy indicator? What should Americans expect moving forward, and when will the recession really end? According to Fed Chairwoman Janet Yellen, a multitude of factors will tell her when the time is right.

“Ms. Yellen said her dashboard for monitoring economic progress would include
the share of workers who have been unemployed for six months or more, the share
of adults who are holding or seeking jobs and the portion of workers who hold
part-time jobs but say they would rather have full-time occupations.” – WSJ

So while the news coming out of the meetings leaves more to be desired in terms of understanding the actual state of the economy and strength of the labor market, expectations can be made moving forward. All indicators show that the tapering process will continue as planned, $10 billion less bond purchases happening each month, and depressed rates while inflation sits below its targeted level. While the new measure for the state of the labor market certainly is more indicative of its actual all-around health, the Fed left much doubt for when it will finally be ready for a rate increase.

QE May Be America’s Friend, but It’s Not Mine

After the Great Recession, the Fed began the use of Quantitative Easing (QE) in an attempt to put the economy back on track.  With short-term interest rates already near zero, the Fed began purchasing unconventional, longer-term assets in order to bring down long-term interest rates.  And much of the world followed suit.  Since the Great Recession, the Federal Reserve, ECB, Bank of England, and Bank of Japan have injected more than $4 trillion of additional liquidity into the world economy.  Looking at the results of this “easy money” policy, QE seems to have been beneficial.  Indeed, more QE, coupled with the elimination of the Zero-Lower-Bound, would likely have made America’s long economic recovery much faster and much less painful.

According to a study by McKinsey, low interest rates brought about by QE have saved the federal governments of the USA and European countries over $1.6 trillion since 2007.  This savings on debt-interest payments has allowed governments to achieve higher levels of spending and reduced levels of economic austerity (at least in some places).  The private sector has also benefited, with non-financial corporations saving over $700 billion in interest payments in the last five years.  This savings has helped boost profits for US corporations over 5% in a time when the economy was struggling, helping to contribute to a reduced unemployment rate (even though this recovery has been very slow and painful).

Nevertheless, as is commonplace in economics, what benefits the greater economy does not usually benefit individuals.  Take a recession, for example.  During an economic downturn, individuals benefit from increased savings.  Increased savings allows individuals to tolerate a slump better, ensuring adequate income at a time of economic uncertainty.  Increased savings, however, is bad for the economy.  The aggregate economy requires increased levels of spending to boost aggregate demand and help pull the economy out of its slump.  In this way, we can see that the micro-level and macro-level goals do not necessarily align in economics.

Unfortunately, this goal divergence applies to QE as well.  I have already pointed out that QE greatly benefited the aggregate economy by lowering interest rates and making it easier for governments and corporations to spend.  For individuals, however, these low interest rates have had a devastating effect.  Most notably, low interest rates have wreaked havoc on the cash flows of retired, fixed-income investors.  Indeed, household in the USA and EU have lost over $600 billion in net interest income since the introduction of QE.  For those in retirement relying on cash payments from interest-bearing assets, this typically means a reduction in income and a reduced quality of retirement.

In this way, it seems that QE has benefited the aggregate economy at the expense of individuals.  It is true that those relying on increased wages have benefited from QE as unemployment falls.  But more senior individuals, who rely on fixed-income assets as their main source of cash, have greatly suffered from lower interest rates.  I do not mean to say that QE is a bad policy.  Indeed, I believe QE, like negative interest rates, is a necessary policy to help control our bleeding economy’s pain.  But the effect of QE on individuals points out that in economics, there is rarely a win-win situation.  Whether it is QE, taxation, subsidies, trade barriers, or any other type of economic policy, there is almost always a loser.

Time to start saving again?

As all Economics 411 students should know by now, quantitative easing – or balance sheet monetary policy – won’t come back to haunt us in any scenario until the economy starts to heat back up. In that case, only by the Fed missing the signs of an economic rebound and failing to act would the U.S. economy be at risk of overheating. Professor Kimball defends this aspect of QE in many of his posts, but here is one that describes this scenario in more detail than I will go into on this post. In today’s Fed policy meeting, it became clear that some officials are already talking of dumping off assets accumulated through QE in the near future. Selling off these assets would mark an attempt to start bringing up the Federal Funds Rate and other short-term interest rates. Fed “Hawks” brought up the dangers of inflation as the tapering continues and is expected to end in Q4 of 2014.

Is it too early to talk about a boon, and of increasing rates that for years have been stuck near the zero lower bound? I don’t think so. With a strategy as new as QE, it seems that caution is much better than the alternative. And really, how far is the U.S. economy from finally ending talk of recession? As Fed chairwoman Janet Yellen has said, the jobless rate target will remain at 6.5% for the foreseeable future. But how far off is that? Recent news confirms that a strong recent push has brought America down to just a 6.6% unemployment rate. That’s exactly why planning ahead – even to something so foreign to us as inflation has been for the last few years – is imperative for the Fed, and now.

“‘We are a lot closer to a normal economy than we’ve been in a long time,’ James Bullard, president of the Federal Reserve Bank of St. Louis, said Wednesday in an interview. He sees the jobless rate hitting 6% by the end of the year, which he said could put pressure on officials to start considering rate increases.” -WSJ

While Mr. Bullard’s forecast of 6% seems to be an answer to our economic prayers, there is still a collective worry about the effects that dropping out altogether from the labor force have had. Some believe that while 6.5% sounds great, it is a long shot from the actual state of the U.S. economy at this point. And it’s only fair to assume we have a way to go, especially before the general population is convinced that the recession has passed. Most estimates have interest rates rising by late 2015 at the earliest, as inflation stands well below anything worrisome. It seems like a problem the U.S. economy won’t need to face for a while, but the inflation “Hawks” are starting to circle at the Fed.

Rising Interest Rates

In the aftermath of our most recent exam were back at it again, blogging about current topics in the world economy. After spending many hours studying Professor Kimball’s material I found it only fitting that when I logged on to the Wall Street Journal the main page housed an article about the Fed debating on the appropriate time to raise the fed fund interest rates. The Fed has already began backing off Quantitative Easing strategy and allowing the interest rates to rise on both ten year treasury bonds and longer mortgage back securities. The FOMC meeting again agreed in January to cut assets purchases by another $10 Billion in the upcoming month, dropping the total to $65 Billion in the month. Many people except the Fed will continue cutting asset purchase by $10 Billion a month for the foreseeable future.

The article in the journal also addressed the Feds most current debate on allowing the federal funds rates to rise sooner than the previous target of 2015. The entire board was not in favor of the increased timeline, however at least two of the members found it appropriate to start the discussion of lowering the rates within the next six months, or possibly sooner. These members found that data points showing strong economic growth may warrant shortening of the time line.

There seemed to be two sides to the argument. Some argued the housing markets and job markets weak ending in January are both signs that the Fed Funds rate should remain pinned at zero, and even went as far as voicing the opinion to back off the constant cuts of $10 Billion a month. The opposing side argued back that these weak data points were a direct result of an extremely cold winter and expect them to bounce back to normal growth levels by in the short future.

My personal opinion is that the Fed should allow the fed funds rate to start creeping up past the zero lower bound its bin pinned at for the past five years. I think the Fed buying back up the 3-month treasury bills before it has completed its quantitative easing strategy would be beneficial. If all the high powered money came back “alive”, they would be able to quickly buy it up before an economic disaster. Starting to raise the fed funds rate before quantitative easing is completely undone will also work as a safe guard, since all interest rates are tied together it is unlikely the fed funds rate will surpass rates on longer term assets.

(Revised) The Fed in Stock and Bond markets.

I think that the meaning of the Quantitative Easing can also be found in functioning of financial markets and monetary policy channel. As we know, current monetary policy mechanism heavily depends on well-functioning of financial markets. For example, the interest rate channel mainly works through interactions between the short term interest rates and the long term interest rates. If the Fed changes the Federal Funds rate, then short term interests rates and long term interest rates change, and eventually its effects reach economic activity.

If the financial markets function normally, lowering the short term interest rates can lead to stimulate the economy. As the Fed lowers the Federal Funds rates, short term interest rates fall and long term interest rates fall consecutively. Financial institutions will borrow short term money and invest them in long term assets such as corporate bonds. This leads to decrease of borrowing costs of companies and eventually increases investments.

But, this time financial markets stopped functioning normally because financial institutions suffered from heavy loss, and credibility of long term assets got severely damaged. These financial markets situations cause monetary channel not to work properly. Therefore, malfunctioning of monetary policy channel caused by the extremely strained financial markets conditions can be regarded as one of the reasons that make the Fed enter into this new monetary policy territory, balance sheet monetary policy. In that sense, the Fed’s decision to buy MBS seems to be very sound in terms of stimulating economy.

Big credit events like the collapse of the Lehman Brothers greatly increased the counterparty risk in the financial transactions, and money does not flow properly in the financial markets. Financial institutions worried about creditworthiness of financial transaction counterparts. Due to the development of financial engineering, complex financial techniques like asset securitizations makes financial institutions harder to estimate credit risk of counter party.

As a result, financial flow to credit markets such as stocks and corporate bonds decreased sharply and money stayed in the safe markets like treasury bill markets. Even though the Fed provided excess money in the markets, money might not flow to credit risk markets properly. This lack of financial flow to credit markets hurt real economic activities and eventually resulted in the Great Recession. In that sense, I think that if the Fed had directly bought stocks and corporate bonds, financial markets could have returned to its normal functioning more quickly, and economy could have shown more rapid recovery.

I think there are three major concerns about the Fed’s participating in those credit risk markets. First concern is about causing inflation, but this concern is not a big deal in this economic situation of lower than natural outputs as Professor Kimball well explained in his blog, “Balance Sheet Monetary Policy: A Primer”. Other concerns are increase of credit risks in the Fed balance sheet and moral hazard problems in the financial markets.

In regard to increase of credit risks at the Fed, which will result from buying credit risk assets like stocks and corporate bonds, I cannot think of any serious trouble in the Fed’s monetary policy implementation. Even though corporate bonds or stocks that the Fed buys go bankrupt, it does not have any serious impact on the Fed ability to conduct monetary policy. That’s because the Fed ability to conduct monetary policy comes from its authority to provide money and the Fed does not rely on any other financial resources to conduct monetary policy. So, the loss in the Fed balance sheet does not any substantial effects on its monetary operations.

Certainly, however, deficit of the Fed would be embarrassing to the Fed. The Fed may worry that deficit would cause any unnecessary intervention of monetary policy from the Government or the Congress. The Fed would also worry about any stigma from its deficit. I think that we can approach this credit problem by adopting a new accounting principle for central bank profit and loss. Specifically, we can separate the Fed’s loss originated from monetary policy implementation from its operating profit and loss, and treat the loss in special accounts. By doing so, I think we can avoid misunderstanding of the Fed’s loss as bad investment. This special treatment for the Fed’s loss can be justified in the sense that the Fed is intentionally taking credit risk for economic recovery.

Another problem is the increase of moral hazard in the financial markets. As the Fed is ready to rescue the plummeting financial markets, then financial institutions are more likely to bear more credit risks and to take aggressive investment behaviors which might cause financial crisis. But I think that this moral hazard problem is indispensable when dealing with financial crisis. Without taking the risk of increase of moral hazard, the Fed cannot revive financial markets. And the way to minimize the related moral hazard is another policy task to deal with.

I think one way to reduce the moral hazard is that the Fed does not buy individual company’s stock or bonds but buy market index products, which are made to keep track of market index like Dow Jones Industrial Average Index, S&P 500 Index or other bond market index. By investing in market index products, the Fed can reduce unnecessary suspicions and interference from other stakeholders.

As the economy recovers from the Great Recession, we need to retrospect the past, and to think about how to deal with the future crisis. I think that one possible solution for financial crisis is the Fed’s direct involvement in stock and corporate bonds market. If there is any legal restrictions for the Fed’s operation in those credit risk markets, legislature think about change of the law to allow the Fed to participate in stock and corporate bonds markets.

 

Fed Ignore Emerging Market Slump

The Federal Reserve followed expectations on Wednesday and voted unanimously to taper the current quantitative easing scheme, from $75 billion in January to $65 billion in February.  The Fed also extended their reverse repo experiment at the New York Fed and reiterated their commitment to short term interest rates being zero for the near future.  Although these policy actions were in line with expectation, some had been calling for the Fed to halt tapering to prevent the current crisis in foreign markets from getting any worse; however, the Fed ignored the current slump in foreign markets, highlighted by the weakening Turkish lira and South African rand.

A weakened currency hypothetically should help the net exports of these emerging markets by making the products cheaper to foreign buyers.  However, a weakening currency also make foreign debts larger in terms of domestic currency, and thus harder to pay.

Although the slump was certainly a complex mix of many factors, the planned reduction in quantitative easing is being blamed as a factor for the capital outflows from emerging markets.  The idea behind these claims is that as the government reduces the amount of stimulus through QE, investors will have higher available profits in the domestic markets, because the government won’t be driving up prices as steeply.  Thus, investors will take money out of the the riskier emerging markets to the more stable returns of the domestic market.

By continuing with the intended tapering policy, the Fed made a decision not to consider the potential adverse effects of their decision on foreign markets.  In fact, “Fed officials made no mention of these trends in the statement released Wednesday.”  In recent years, this has been the general strategy of the Fed, with chairman Ben Bernanke stating in 2011, “It’s really up to emerging markets to find appropriate tools to balance their own growth.”  Foreign central banks have taken this policy to heart in recent days, with the Turkish central bank raising it’s overnight lending rate over 400 basis points , and other small central banks enacting similar policies.  While their policies haven’t been very effective, these emerging markets clearly understand that the U.S. will not shape their policy to accommodate them.

I believe that the Bernanke and the Fed made the correct decision not to react to the fluctuations in the foreign markets in their policy decisions.  Some critics believe that many of these emerging markets had entered into a sort of bubble spurred on by high liquidity and large capital inflows, and thus a weakening in the markets were only natural.  Also, today, the emerging market currencies that were hit hardest last week have now recovered slightly, and are trending in a direction favorable to foreign governments.

Furthermore, I believe that the Fed should enact the monetary policy that is best for the U.S. economy.  Since the U.S. economy is not highly dependent on emerging markets, the Fed probably shouldn’t put too much thought into how their policy will affect emerging markets.  Also, if the U.S. economy improves overall, the foreign markets stand to benefit; what is good for the U.S. economy is good for the emerging markets.