Jim Pethokoukis wrote yesterday with two cheers for Bernanke and our brave new monetary policy. I am feeling less cheered. Indeed, I'm a bit frightened by where we are going.
As noted by economists Larry Ball and one-time Ricochet contributor John Taylor, we have created an entirely new monetary policy regime this week, in contradiction to the Taylor Rule. This fall, The Fed had embarked on purchasing $40 billion in mortgage-backed securities (MBS) each month, to be paid for by selling off short-term Treasury securities (T-bills). This would induce private lenders to leave the MBS market and hopefully make loans to the business sector. Meanwhile, short-term interest rates would rise.
On Wednesday the Fed announced that they could no longer really do that, as they had sold all the T-bills they thought prudent. So now they will pay for those MBS with new reserves. And they will now purchase an additional $45 billion a month of long-term Treasuries (T-bonds), also paid for with new reserves. As the graph in Professor Taylor's post makes clear, the expansion of the monetary base is exponential.
Reserves eventually become money. Currently, most reserves are held by banks who receive interest on them from the Fed. In short, the Fed is using its profits from operating in money markets to induce banks not to lend the reserves they are printing with one hand, while manipulating interest rates to encourage borrowing with its other. And this process threatens to debase our currency. The lone dissenting vote from Wednesday's meeting, Richmond Fed president Jeremy Lacker, noted the Fed had only a few years ago agreed with Treasury that steering credit is not a job for monetary policy. Yet now that's precisely what they're doing.
"No, King, it doesn't have to be this way. The Fed will reverse and correct this in time." Perhaps so, but it has never had to do anything like this before. The Fed expanded its reserves five-fold between the depths of the Great Depression and World War II -- and never went back. The price level doubled between 1933 and 1948.
Today, the Fed has increased reserves from $800 billion to $2.6 trillion -- a number that it says will rise $85 billion more each month until it gets an unemployment rate it feels better about, or until the inflation rate reaches a level well above its target. (The last two 4-week periods have had increases of $24 billion and $43 billion). This requires a foresightedness and deftness in monetary policy that the Fed has given me no reason for me to believe they possess. "Trust me, I'm from the Federal Reserve," anyone?
Prof. Taylor notes that each time we have deviated from the previous regime we have eventually had a recession, often with a serving of inflation on the side. I expect a double serving this time.