The Fed cannot save the day

I was on BNN’s Headline with Howard Green last week as the Fed made its rate decision and announced it would extend Operation Twist to the end of the year. Here’s the video.

On the show, I said that the Fed’s move wasn’t a big deal because it wasn’t even clear that Operation Twist worked. After all, isn’t the US economy at stall speed right now? Remember, the original Operation Twist from 1961 is mostly considered to have been a failure. Knowledgeable economists like Stephen Roach predicted this Operation Twist would fail too.

I also said that of the Fed’s three preferred unconventional policy tools, Operation Twist, traditional QE and rate easing via permanent zero rates, extending permanent zero would be most "effective". Why? Long-term interest rates are a series of future short-term rates. If the Fed announces it will keep rates at zero percent for even longer, the term structure of the US yield curve will immediately flatten without the Fed even having to buy a single Treasury. Permanent zero reduces rates because it targets price/rates while Operation Twist doesn’t because it targets quantity.

But, the Fed has to do something. And they have to do it before the election cycle draws near. Everyone and his sister is calling for more easing, so what else is the Fed going to do? The question is whether what they do actually works. Janet Yellen said recently:

Research by Federal Reserve staff and others suggests that our balance sheet operations have had substantial effects on longer-term Treasury yields, principally by reducing term premiums on longer-dated Treasury securities. …our portfolio actions are currently keeping 10-year Treasury yields roughly 60 basis points lower than they otherwise would be. Other evidence suggests that this downward pressure has had favorable spillover effects on other financial markets, leading to lower long-term borrowing costs for households and firms, higher equity valuations, and other improvements in financial conditions that in turn have supported consumption, investment, and net exports. Because the term premium effect depends on both the Federal Reserve’s current and expected future asset holdings, most of this effect–without further actions–will likely wane over the next few years as the effect depends less and less on the current elevated level of the balance sheet and increasingly on the level of holdings during and after the normalization of our portfolio.

So, Fed Vice Chair Yellen wants us to believe that yields are lower and stock markets are higher because of the Fed and by inference that this has significance for the real economy.

First, as I said previously, the Fed’s actions have not lowered rates. The Fed’s QE2 raised inflation expectations, causing interest rates to rise and nullifying the effects of lowered risk premia. Second, low rates are toxic to savers and bank net interest margins. When credit demand is weak, the loss of interest income overwhelms the reflationary effects of low rates. Third, as Yellen herself has noted, it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage. Low rates encourage releveraging, not deleveraging. My friend Professor Stephanie Kelton puts it this way:

Krugman, Baker, Yglesias, Hayes — everyone seems to have gotten the memo.  Ordinarily, they insist, the Fed could reach into its tool kit and deliver a powerful shot of economic adrenaline that would set off a frenzy of borrowing and spending. But that typically potent transmission mechanism is said to be broken because borrowing costs are already essentially zero. The curse of the so-called Zero Bound! What to do?  The Fed must move into uncharted territory. It must “do more.”


The zero bound isn’t the problem. Brazil’s central bank has cut its policy rate by 400 basis points since August 2011. That’s 4 percentage points in under a year! Meanwhile, growth continues to slow and inflation is falling. Why? Brazil isn’t up against the zero bound (far from it, rates are at 8.5 percent). The problem is that monetary policy is a blunt instrument (at best).  Committing to a higher inflation target isn’t going to pull us out of the economic doldrums.


In any event, we’re in a balance sheet recession. We should be encouraging the private sector to borrow less, not taunting people with negative interest rates and encouraging them to leverage up. And we should recognize that the government’s deficit is the key to helping the private sector de-leverage.

Here’s my conclusion: the demand for credit is still weak. Some point to the importance of the psychology of balance sheet recessions. Others like myself point to the debt stress from falling asset prices and weak job and income growth. Either way, absent a rebound in incomes or a reduction in private debt, the recovery will remain weak irrespective of how many supply side solutions the Fed implements. If the US (the UK, Ireland or Spain) wants to get the credit ‘transmission mechanism’ working again they will need to increase demand for credit by reducing real debt burdens as a percentage of income or increase income and job security enough to allow debtor’s to focus instead on today’s low debt service costs. If these countries focus on deleveraging instead of releveraging, that would necessarily mean large private surpluses and therefore large government deficits in the absence of significant currency depreciation.

Bottom line: The real solution has nothing to do with the Fed because the constraints are demand side and not supply side. But people will continue to exhort the Fed to do more and so they will do more.

  1. Dave Holden says

    Yes, households are over leveraged given their income and job security. But my presumption is that this leverage isn’t evenly spread across the spectrum of goods but is mainly in property. While QE helps on debt costs in this regard it hurts on incomes via price inflation and increased business input costs. It’s unclear to me whether the good outweighs the bad there. Either way I think it’s socially regressive. In our debt based monetary system what’s needed is a leveraging in productive debt and deleveraging in unproductive debt.

    1. David_Lazarus says

      Yes the pluses of QE do not make up for the long term costs of inflation, but higher inflation is part of the planned solution to make loans affordable again. Great for the debtor, lousy for everyone else. Yes it is socially regressive but that is what the 1% want. They do not want to pay for their mistakes, that is what the little people are for.

      I do agree with your final statement but overall everywhere is mired in debt. So even productive debt is still too high, primarily because the assets they buy are so overvalued. It also factors in as a cost of production and they need to fall in order for an increase in competitiveness. That is not being allowed to happen with current policy and all the cuts required to increase competitiveness are being imposed on Labour. That means eventually the system cracks and extremist governments get in that promise to end that pain for the workforce.

      1. Dave Holden says

        Yes it’s clearly a policy that suits the 1%. But I also think its a policy that neoclassical economists believe in. People like Bernanke, Krugman and in the UK Danny Blanchflower, Posen really think releveraging can be restarted without any deleveraging. I suspect this is because they really don’t understand the mechanisms behind credit creation.

        1. Woj says

          Good discussion. The breakdown of debt among classes is an important factor in the crisis. Groups with the most debt are also least likely to experience wage growth, which is where neo-classicals hope to see the benefits of higher inflation targets. As a consequence of not understanding that private banks create credit from “thin air”, neo-classicals largely ignore private debt and the corresponding deleveraging. Higher inflation, in this sense, is also a means to encourage greater public spending.

        2. David_Lazarus says

          I doubt that re-leveraging can be achieved, the purpose of de-levergaging is to clear out mal-investment. If you do not do that you build inefficiencies into the economy. Also how would you know the value of the investment if it is helped by false market pricing. That is what represents the housing market right now. Most people doubt that house prices can fall much further. I think that they can fall significantly.

  2. David_Lazarus says

    The problem is that governments are actively trying to reflate the bubbles. Deleveraging is really only going on at the margins, especially in the UK. Many investors are talking in terms of jumping back in once prices stop falling. As you say this is a demand side problem yet the policies are not going to help. Mock stimulus will be offered probably more to discredit Keynesians rather than actually kick start the economy. Debt is the problem and that is killing demand. So credit write-downs are needed and then a massive stimulus could be used but unless asset prices fall substantially I do not see the stimulus working because any gains will be sucked up by the banks to prop up the asset prices.

    Everyone seems to be concerned about “deflation” when asset prices are trying to revert to the long term mean. When the reality kicks in then prices will crash and the Depression will have started and with governments drained of any firepower.

    With all the capital flows to safe havens I do start to wonder if this is just another poisoned chalice? This will hold asset prices up in the safe havens but delay them actually dealing with their own structural problems.

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