Note: Further readings are provided at the end of this post. Another copy is available at thefedchallenge.blogspot.com
In the last post, I mentioned the decision of Time magazine to select Fed Chairman Ben Bernanke Person of the Year. It is certainly good news for Mr. Bernanke before a full Senate vote to give him another 4 years as Fed Chairman.
The nomination of Mr. Bernanke faces growing opposition from almost every type of economists and financial experts.
The first group, as University of Oregon economist Mark Thoma pointed out, is libertarians who argue for the abolishment of the Fed. I think we would have to go back to 1830s to find a politician who wanted to destroy the U.S. central bank. That person would be President Andrew Jackson. Of course, the bank that Jackson wanted to destroy was not the Federal Reserve, which was created in 1913, but the Second National Bank.
One of the most frequently-asked questions couple of years ago when the economy was booming was whether we would need the Fed. The fact is that the Fed often times used the Taylor rule, formed by Stanford economist John Taylor in 1990s, to formulate monetary policy. The Taylor rule uses output and inflation gaps to determine the target for the Federal Funds rate. That is, any economist, who can calculate output gaps and inflation gaps, could calculate the target for the Fed Funds rate. So why would we bother having the Fed do the task that any economist can do?
However, this recession has shown that Taylor rule does not work effectively during tough times. Earlier this year, when the Fed lowered the Fed Funds target at 0-.25%, the economy was free-falling; the output gap, the difference between the actual output and potential output, was enormous that cause the Taylor-rule Fed Funds target down to -5%. Obviously, the Fed could not lower interest rates below zero. And that is when we began to realize that we need the Fed.
Thoma mentioned Ron Paul’s comment:
Throughout its nearly 100-year history, the Federal Reserve has presided over the near-complete destruction of the United States dollar. Since 1913 the dollar has lost over 95% of its purchasing power, aided and abetted by the Federal Reserve’s loose monetary policy. How long will we as a Congress stand idly by while hard-working Americans see their savings eaten away by inflation?
Mr. Paul and libertarians in general wants zero inflation. But that seem unrealistic. We don’t have an economic model in which the aggregate demand curve or aggregate supply curve is horizontal.
The second group is probably the Wall Street Journal. The Journal argues that the Fed has not been aggressive enough in fighting inflation. According to Mr. Bernanke and the FOMC, inflation trends remain subdued and inflation expectations are stable for the time being. That is true but the argument that inflation will be a problem in the future is worth being addressed. Financial institutions are keeping some $1 trillion reserves at the Fed. As the condition of the financial market is improving, these institutions might begin to lend their money to the consumers and businesses, which are in need of new loans to refinance their homes or to purchase more capital goods. This would put more upward pressure on inflation.
Personally, I think this scenario is unlikely to occur any time soon. The riskiness of the overall economy is still high. Banks are tightening credit that they are unlikely to lend their money out to small businesses. Business investment has been improving but not fast enough to push the economy back to its potential. It is unlikely that banks will transfer their $1 trillion in reserves into circulation.
Many economists, however, argue that high inflation will occur not because banks will suddenly make their reserves available for borrowers, but because perhaps the Fed might not be able to exit from its quantitative easing quickly enough to avoid inflation. The Fed’s balance sheet will continue to stand at $2.3 trillion until March as it will end the MBS purchase program. What can the Fed do to unwind the money that it has created? In my presentation at the National College Fed Challenge, I pointed to the four exit tools that the Fed had – Reverse Repurchase Agreements, Treasury Supplementary Financing, Term Deposits to Banks, and selling Treasuries.
The Fed implemented Treasury Financing tool in Fall 2008. Here is how it works. As the Treasury sells U.S. government securities, it will keep some portion of the buyout at the Fed. The Fed, in turn, will drain out the cash out of the circulation. However, I don’t think this program is going to work, at least for now. Government spending has been increasing tremendously in the last two years. And a lot more is going to be spent. And without the money from Treasury sales, there is no way that the U.S. government can spend on anything.
Selling long-term or short-term Treasuries is not practical either. If the Fed sells Treasuries now, the yields on Treasuries will rise as the prices decrease, thus, increase interest rates across the board. At this economic climate, higher interest rates will diminish the ability of the consumer to finance their homes and businesses to invest in capital goods.
So now it comes down to the other two policy instruments: Reverse Repos and Term Deposits. The New York Fed is “testing” reserve repos and the Fed announced last week that it would begin to implement term deposits. Reverse Repos: the Fed sells an asset to a financial institution with a promise to buy it back in a specified date in the future. Obviously, this strategy will help the Fed be more tightening in dealing with its balance sheet. But the question, I think, is about what kind of assets the Fed is going to sell. Most of the Fed’s assets are U.S. Treasuries and MBS that the Fed bought from banks. As explained above, selling Treasuries is not practical. So, what about selling MBS? Not really. The Fed bought MBSs from banks to support their value in the market. Banks were eager to sell those assets to the Fed. So, what banks are going to be eager to buy back their toxic assets? Term Deposits: the Fed borrows money directly from banks. We will have to wait and see how this works out. I think it is certainly a good tool.
The third group against the nomination of Mr. Bernanke, I would say, is “liberal” economists. These economists argue that the Fed is paying too much attention to inflation, not more easing policy to stimulate employment. Inflation rate for 2009, I think, was around 1.5% or so, still below the commonly targeted level of $3%. Liberal economists argue that the Fed should be committed to 3-percent inflation rate, which means that more easing monetary policy should be put in place. One question from economist Brad Delong to Mr. Bernanke is why the Fed has not committed to 3% inflation rate. Mr. Bernanke’s response is that if the Fed was committed to a specific inflation rate, it would turn out to be higher in the future. Also, higher inflation rate will definitely stimulate employment, but higher-than-targeted inflation will, in contrast, worsen employment situation.
So, what is my position on the nomination of Mr. Bernanke? I am not confident that we can get a better person for the Fed Chairman post than Mr. Bernanke in terms of intelligence and knowledge. However, I think that Mr. Bernanke, and the Fed, made huge mistakes during the last 4 years, especially in identifying the bubble in the housing market as well as in the financial market and consumer protection. The only questions that I, and many others, have is whether Mr. Bernanke is going to repeat his mistakes in the next four years as the Fed Chairman. One thing that I have noticed about economic advisers of the Obama administration is that “you want to cure a disease, you’d better pick the person who creates the disease.” Larry Summers, who had turned Wall Street into a non-regulation market, is Obama’s chief economic adviser. Tim Geither, who oversaw the business on Wall Street before the crisis, “helped” cause the financial crisis. So perhaps Mr. Bernanke, one whom I think helped create the last financial crisis, is the one that everyone is looking for.