Fed easing risks diminishing returns
In theory central banks are omnipotent to create inflation. In practice, it is not so simple. With the U.S. economy slowing, the Federal Reserve will likely consider whether and how it might further ease monetary policy. But would the Fed buying yet more bonds and injecting more liquidity into the banking system create more credit and stimulate more economic activity?
There are four rationales that could explain why the Fed might now increase the size, or change the composition, of its balance sheet. While the Fed could act, it risks diminishing returns and perverse
First, there is the “bank liquidity” rationale. To avoid a bank panic a central bank can rapidly expand its balance sheet to keep private bank balance sheets stable.
This rationale supported the Fed’s actions in 2008 and the European Central Bank’s recent longer-term refinancing operations. But it does not provide a compelling reason for the Fed to act in response to economic weakness.
With $1.5 trillion of excess reserves in the banking system, it is hard to believe we need more liquidity to stem bank runs. If bank troubles in Europe, or elsewhere, were to escalate, the Fed could further extend its swap lines with other central banks. But without further bank strains and an explanation of why current bank reserves are insufficient, this rationale would not support further Fed balance sheet expansion in response to economic weakness.
Second, there is the “asset price” rationale which rests on the theory that if the central bank buys assets it can create momentum behind a rise in asset prices, stimulate investor animal spirits and create a virtuous cycle of confidence that will support economic expansion. This seemed to be part of the justification for the Fed’s actions in the autumn of 2010. While it did drive risk assets higher for a few months, there was little follow-through in economic activity in 2011. This approach provides little more than a bridging operation and the question remains: a bridge to what? Finally, there is the “radical monetarist” rationale to avoid deflation by flooding the banking system with enough “money” to prevent prices from falling.
This is based on the idea more central bank liabilities will eventually translate into “too much money chasing too few goods and services” at least so as to avoid a fall in the general price level. There are real challenges the Fed would have to overcome to pursue this rationale.
This is not a response merely to economic weakness but, rather, to the likelihood of deflation. Given the continued deceleration of all measures of monetary velocity, the Fed would have to be ready to balloon its balance sheet to overcome the lower money multiplier.
What assets would the Fed buy? More Treasuries? Would the Fed embark on such a radical course in a presidential election year? Perhaps the Fed could buy foreign currencies, engineer a much weaker dollar and, thereby, stimulate inflation and growth.
Would the rest of the world permit this? I doubt it. They would likely respond in kind and we would all have a real currency war.
Nor is it clear the U.S. external sector is large enough to import enough inflation to make a difference.
If energy and commodity prices soared, would American consumers “chase” consumption opportunities or would they suppress consumption and trigger a recession?
Recent experience suggests the latter. How much “chasing behavior” would we get in a recession? Engineering a dollar collapse would be to play with fire and gasoline. It might create inflation or it might create a depression. The Fed is not “out of powder.”
It could keep expanding its balance sheet or twisting into more Treasury purchases. If it thought deflation was around the corner, it could try radically expanding its balance sheet. The question is not whether they could do this. The question is whether it would make any sense.
Peter Fisher is head of fixed income at BlackRock.