It’s time for the Fed to rethink quantitative easing The Federal Reserve building in D.C. (Chris Wattie/Reuters) Opinion by Lawrence H. Summers August 27 at 2:01 am Taiwan Time The American experience in Vietnam and Afghanistan teaches an important lesson. Making policy incrementally — focusing on adjusting the current policy path to avoid near-term pain, rather than stepping back and assessing whether the current state of affairs makes sense — can lead to terrible outcomes. Indeed, this was the central lesson Daniel Ellsberg drew from the Pentagon Papers. The same principle applies in economic policy. As the Federal Reserve meets virtually for its annual Jackson Hole retreat, it should, but probably won’t, step back and reassess its continuing quantitative easing policy, which has gone on for too long. The current policy is explicable as the result of a month-by-month decision-making process, following the urgently needed steps the Fed took at the beginning of the coronavirus crisis. But viewed from the perspective of current economic conditions, it cannot be justified and presents its own danger. Quantitative easing is a policy of creating money in the form of providing interest-paying reserves to banks and buying up Treasury bonds and other government-guaranteed securities. This step was clearly warranted when bond markets were illiquid, highly volatile and in danger of collapse — the case in 2008 and 2009 and again in the covid spring of 2020. As with any highly potent medicine, managing its withdrawal is delicate. But the beginning of wisdom is seeing that the quantitative easing prescription makes little sense today. First, since the Treasury is the economic owner of the Fed and receives its net income, when the Fed substitutes short-term bank reserves for longer-term debt, the government is unaccountably “terming in” the debt and shortening the maturity of its liabilities. This approach makes little sense — no homeowner in the present circumstances would opt for a variable-rate mortgage with rates so low. It is unwise at a time of unprecedented growth in federal debt and prospective deficits, along with record-low real long-term borrowing costs. If ever there were a moment to increase longer-term borrowing, it is now. Second, the idea behind quantitative easing is to lower medium- and longer-term interest rates and increase asset prices so that the private sector will spend more. Why is this still a sensible objective when job openings are at a record high, inflation is running well above the Fed’s target, and housing inflation is not yet reflected in official indices even though the average new tenant is paying 17 percent more than her predecessor? And how high-quality can investment be if it would not have happened with a 1.7 percent 10-year rate and will now occur because of even lower rates? Third, even accepting the idea that now is a good time to promote more spending and that it should be financed by what is in effect floating-rate borrowing, there is no case that the best way to inject money into the economy is through buying financial assets. That mechanism supports the wealthy who hold these assets, rather than the bulk of the population, at a moment of nearly unprecedented inequality. And at a time when bubble risks are surely very high, the goal of policy should not be further inflating asset prices. In the face of these considerations, why is the current policy going to be maintained for a year or more, even if tapering begins soon? Proponents point to delta variant uncertainty. I suspect we are near peak delta given vaccinations and rising immunity among the previously infected. But suppose delta increases. Then fewer people may go to work, and particular sectors, such as travel and entertainment, may suffer. Neither of these problems is overcome by printing money. And to the extent supply is reduced, delta may increase inflation risks. Some argue that inflation is transitory. Of course, that is true of much of the double-digit core consumer price index (CPI) inflation rate in the second quarter. But the economy’s two largest markets — for labor and housing — suggest that significant inflation will be sustained; so do reports of rising shortages everywhere, from supermarket shelves to semiconductors. The Fed used to believe in preempting inflation. Then it announced it would not act until there was evidence. Now it is in a posture of not even beginning to reduce the most generous monetary accommodation in history until presented with conclusive proof of excessive inflation. This is the crux of the matter. The Fed is running quantitative easing at current levels not because anyone has analyzed that as appropriate given current conditions. Rather, there is a felt need to maintain credibility given previous commitments and a reluctance to accept the immediate pain and dislocation associated with changing course, coupled with faith in the ability to manage the situation down the road. This kind of incrementalist thinking did not end well in Vietnam or Afghanistan. Of course, it is also true, as Afghanistan demonstrates, that precipitate change of a problematic course can be very costly. The Fed cannot immediately abandon quantitative easing. But its annual Jackson Hole retreat this weekend should be an occasion for planning withdrawal from a strategy that has already outlived its usefulness. Lawrence Summers is a professor at and past president of Harvard University. He was treasury secretary from 1999 to 2001 and an economic adviser to President Barack Obama from 2009 through 2010.
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