The Federal Reserve Is in a Bind

Janet Yellen, Chairman of the Federal Reserve System
Wikimedia Commons/United States Federal Reserve

Wednesday and Thursday, Janet Yellen, the Chairman of the Federal Reserve, gave one of her periodic reports to Congress on the operations of the Federal Reserve. She was grilled for over three hours on Wednesday before the House Financial Services Committee and again on Thursday before the Senate Banking, Housing and Urban Affairs Committee. With the Federal Reserve coming under increased general criticism for their policies of the past eight years or so, and especially for their recent increase of the Fed funds rate to be within the band from 0.25% to 0.50%, Congress was not in a mood to be particularly forgiving. This was even true among some of the Democrats!

Yellen’s Testimony

In both days of testimony, the Republican chairs of the committees cited a letter from an impressive list of Economic Nobel Prize winners, former Federal Reserve Governors and Presidents, and other eminent academic economists favoring monetary policy making by monetary rules. They also both noted the vast increase in the regulatory power of the Fed over banks mandated by the Dodd-Frank Act.

In her initial report to both committees, Yellen noted improvements in U3 unemployment, but also noted the U6 unemployment rate was still above its level before the Great Recession. She also mentioned that although there had been “moderate growth” last year, the GDP growth in the last quarter of 2015 had slowed to an estimated annualized rate of 0.75%. Economic headwinds caused by the increasing strength of the dollar, increasing inventories, and decreasing exports were cited. She also mentioned how decreasing oil prices had caused oil companies to slash investments and layoff employees. In addition. she gave evidence of a continuing faith in the “wealth effect” that would be afforded by a growing stock market, albeit in a negative manner. She complained of how financial markets have grown less conducive to growth with their recent declines. I fear this continued faith will get us in even more trouble in the future, as I will explain later. Just as troubling to me (albeit expected) was her statement she expected economic activity overseas would soon pick up due to “highly accommodative monetary policy” by other central banks.

One other part of Yellen’s prepared testimony that struck me was her statement that the Fed was not prepared to unwind the huge balance sheet assets the Fed acquired by their purchase of long-term assets, Federal Treasury bonds and mortgage backed securities, during the various phases of Quantitative Easing (QE). The Federal Open Market Committee (FOMC) thought selling the long-term assets “could be difficult to calibrate and could generate unexpected financial market reactions”. Selling these long-term assets would increase their availability in the markets and therefore decrease their price, which would drive up their yield and increase long-term interest rates. The Obama administration will be grateful!

During the question and answer part of the testimony, the biggest shocker was her statement that a Negative Interest Rate Policy (NIRP) is actively being considered if economic growth does not pick up. Without something new like this, there is not much else the Fed could do to attempt to stimulate the economy monetarily. They could adjust short-term interest rates from a 0.25% floor to a 0% floor, but otherwise they are “out of ammunition”. This fact, I am sure, is why they are reconsidering a NIRP.

The Federal Reserve’s Dilemma

Throughout Chairman Yellen’s testimony, she showed no signs of apostasy from the New Keynesian monetary policy faith. She showed throughout that she believed an accommodative monetary policy would inevitably stimulate the economy, both here in the United States and overseas in Europe and Japan. The problem with this faith in New Keynesian monetary policy is that it has failed big time in both Europe and Japan, not to mention the failure here in the United States of the Fed’s ZIRP and QE. Europe has shown through its experience that NIRP alone does not work to stimulate an economy, while Japan has shown QE alone does not work. Now both Japan and Europe are trying out both QE and NIRP simultaneously in a desperate attempt to restart their economies. There is little reason to believe they will have better success with that.

But there is nothing else left in the Keynesian playbook. The probability the Fed will join Europe and Japan by starting a new phase of QE and adopting NIRP is then very high. In an era of such slow growth that Keynesians are reconsidering their ancient doctrine of secular stagnation, the simultaneous adoption of both QE and NIRP is the only thing left for the Fed to try.

Also, the Fed has yet another motivation to restart QE. The Obama administration, in its mistaken faith in Keynesian doctrines, has pushed the national debt to more than 100% of GDP, approximately $18 trillion. In recent months other governments who held large amounts of long-term U.S.treasuries in their sovereign wealth funds have been dumping those treasuries on the international market at the fastest rate in 15 years, and show no proclivity to buy new U.S. treasuries. The long-term treasuries dumped on the markets decreases their price which increases their yields, thereby increasing long-term U.S. interest rates. This is the interest the U.S. would have to pay to sell future treasury bonds to finance deficit spending. If the Fed does not buy both the dumped treasuries and the future ones, who will finance the U.S. national debt at rates the U.S. government and taxpayers can afford? If the Fed begins to pick up the bill again, by definition it will be restarting QE.

What would NIRP look like in the United States? It would not mean savers would have to pay interest to their banks for the privilege of parking their money with the bank. That would cause such outrage there might well be a revolution! Besides, it is not savers who could stimulate the economy by spending their money. They do not have enough of the green stuff. (The rich have better ways to use their money than to stuff it into savings accounts.) The whole point of a NIRP would be to get banks to lend more of their money out to stimulate the economy. The way that goal could be achieved would be by charging the banks a fee for parking their money in excess reserves (reserves over the amount required by the Fed) with the Federal Reserve. That fee is the negative interest rate payment, since banks would have to pay for their “savings deposits” with the Federal Reserve. That would motivate banks to take all of their money in excess reserves out of reserve to lend to individuals and companies, thereby stimulating the economy.

At least that is the theory. Notice however this has one big, undesirable side effect. Recall that when the Fed went through its various phases of QE, it created a large amount of money to pay the Fed’s member commercial banks for the long-term assets it bought from the banks. A lot of people (including myself!) at the beginning of QE thought the creation of such a large amount of money would create horrendous inflation. However, most of the QE money never went into circulation in the economy; the Federal Reserve paid a small (positive) interest rate for excess reserves, so approximately 81% of the QE created money was recaptured in excess reserves. As a result at the present time the Fed is holding a total of about $2.3 trillion or 12.7% of GDP in excess reserves. What happens to inflation if there is an increase in money supply that is 12.7% of GDP? OOPS!!

The Fed’s Limitations

There is yet another question that has to be answered. Will increasing the money lent to companies actually stimulate the economy? Will the companies take that money and invest it in productive capacity? So far, ever since the end of the Great Recession, there has been little corporate investment inside the United States. Companies apparently did not think they could earn enough inside the hostile economic environment in the U.S. to justify such investment. They still borrowed the money at zero real interest rates, but what they did with it was to buy back their own common stock to increase their earnings per share and decrease their price to earnings ratios. Their actions did benefit their stockholders, but they did not benefit the economy with added productive capacity. Readopting QE and adding NIRP would do nothing to change this corporate behavior.

The Fed’s basic problem is that monetary policy is the wrong tool to use to stimulate the economy, and the right tools are not in their purview. The right tools belong instead to the legislative and executive branches of the government. It is those branches that can reform and cut taxes, especially corporate taxes, and drastically cut economic regulations. However, for the Fed to admit their limitations would be an act of New Keynesian apostasy.

It will be fascinating to see how the Fed reacts.

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