Does the Fed understand QE?
Over the time the Fed has been conducting QE, there has been and continues to be much talk of its failure to achieve its aims*. In this post, I'll look at those criticisms and ask why perhaps the Fed continues to conduct the same policy year after year despite openly admitting to not achieving its objectives.
Fed's QE policy
The Fed argues that by conducting QE (currently $80bn treasuries and $40bn MBS per month) it is spurring the economy into growth. The mechanism by which this is supposed to work sounds great in theory not least of all since it is thought to act through a number of channels. By the Fed acquiring assets from the market, prices rise and yields fall. This creates a wealth effect and reduces the cost of borrowing. It also reduces returns on safe treasury assets and encourages more risky investment behaviour thought to be more productive. Further, by signalling to the market the Fed is willing to conduct such a large scale operation, the Fed is hoping to appear credible in its aims of achieving full employment and 2% average inflation.
All fine in theory. The criticisms however are that none of this works in practice.
The failure of Fed policy
The following chart illustrates how the Fed balance sheet has grown and commercial banks' balance sheets have also grown as intermediaries in the QE process. The 'real economy' balance sheets of the private sector however have been left behind.
Commercial banks are creating customer deposits as those customers give up their treasury and MBS investments. For the private sector, new lending is not taking place at anything like the rate the Fed was intending. Indeed my argument has long been the Fed, through increasing asset prices, is disincentivising the private sector to undertake new borrowing.
In any natural cycle, old things die and are swept away to make room for the young to grow. The Fed is keeping asset prices artificially high which deters new investment in productive assets (just take a look at runaway copper prices). A case in point being housing. Building firms are not reacting to increasing prices by increasing supply, which is the natural law of economics, since they understand that supply will not be taken up by a matched increase in demand. And since prospective home buyers do not have the income to afford the increased home prices, due to the Fed driving up all asset prices, building firms do not commit long term capital to increasing supply.
Surely the key to this problem is to shift the balance of power away from capital and back toward labour. The Fed is lazy if not deceitful to argue increasing asset prices and reducing investment income helps the wider population. It clearly further advantages the rich at the expense of the poor. It does nothing to help increase wages or employment.
The market solution
If the Fed was removed of its powers to control monetary policy and this was left to the market, there may be an enlightening. Whilst the Fed only directly controls the overnight Fed funds' interest rate, it influences the rest of the yield curve through its open market operations (QE) and signalling. The former likely has minimal impact given the size of the market but the latter is important since economic participants believe the Fed and global central banks are 'all knowing'. The thought process is, "If central banks cannot solve the problem of deflation then how can we as mere economic agents possibly have the answer." The answer is not to rely or believe anything Powell or his predecessors say. Put them in the same bucket as politicians. They serve only to keep the peace.
If we did not expect the Fed to have the solution, we would not allow the Fed to conduct QE, there would be no signalling to the market and asset prices would freely float to match supply and demand.
Whilst the fear, not least of all of the Fed, is that removing accommodative policy would lead to a collapse in prices and confidence and hence employment, the truth may be much rosier. A quick adjustment in prices, unfettered by government would allow old, inefficient businesses and industries to die and make way for the new.
Look how we coped with the forced interruption in working practices and employment from Covid.
Whilst the government should not interfere in labour markets they can reduce taxes which are themselves a distortion on price. Reducing employment and sales taxes will act to increase demand.
Just as businesses would not have moved to experiment with home working in such scale as was found necessary due to Covid and yet have found a new source of cost cutting and labour efficiency, the Fed and Government will not experiment with new radical policy until it is forced upon them. Let's hope those less fortunate in society and their future generations do not have to suffer too much longer before change inevitable occurs.