By Yuram Abdullah Weiler

Normalizing the abnormal: U.S. Federal Reserve contemplating QE replay

March 16, 2019

“That’s not decided yet, but it’s part of what we are discussing now.” —San Francisco Federal Reserve Bank President Mary Daly.

The U.S. Federal Reserve (FED) engaged in quantitative easing (QE), a policy of purchasing longer-term securities to stimulate economic activity, following the financial crisis of 2008.  From late 2008 until October 2014, the FED supported a near zero interest rate policy until a program of progressive interest rate hikes was begun in December 2015.  By September 2017 the decision was made to gradually sell off the securities purchased under the QE program, a process which was termed “balance sheet normalization.”  However, by January 2019, the FED has conceded that it is contemplating a revival of QE if needed to bolster the ailing U.S. economy.

According to the latest statement by the FED, “The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.”  In other words, they are prepared to call a halt to interest rate hikes and pump liquidity back in the economy by a return to QE, if economic conditions warrant.  The statement, which was reiterated by San Francisco Federal Reserve Bank President Mary Daly in the epigraph, is tantamount to an admission that the U.S. economy has entered an abnormal phase where low unemployment no longer appears to imply high inflation.  As a result, the FED may again be forced to resort to the abnormal tool of QE in hopes of stimulating the faltering U.S. economy and preventing a repeat of the 2008 crisis.

As the central bank of the U.S., the FED has a dual mandate.  On the one hand, there is the goal of full employment, and on the other, there is the goal of price stability, that is, the control of inflation.  These two contrary goals are related as described by the Phillips Curve, which illustrates the inverse relationship between the unemployment rate and the inflation rate.  In other words, when inflation is low, unemployment should be high and vice versa, and during the 1960s, the two rates seemed to follow closely the predictions published by New Zealand economist A. H. William Phillips in 1958.  In fact, the curve fit the data so closely, that government policymakers began to use it cavalierly in the 1970s as a tool to predict the tradeoff between inflation and unemployment.

In 1973 U.S. president Richard Nixon took the dollar off the gold standard and inflation began to increase, along with unemployment, in contradistinction to the Phillips Curve, thus confounding economists.  The FED raised interest rates to a high of 13 percent to curtail the inflation rate, which by 1974 had risen to over 12 percent, concurrently with the Arab oil embargo.  Predictably, the result of this economic double-shock was a recession, so the FED began to lower interest rates in hope of moderating the unemployment rate, which stubbornly continued to climb, reaching a high of 10.8 percent in 1982.   High inflation continued along with high unemployment into the 1980s, until inflation finally dropped below 4 percent by December 1982, but the unemployment did not fall below 6 percent until 1987.  

Throughout this period of what was then termed “stagflation” the FED raised and lowered interest rates, which at times were as high as 20 percent in 1979 and 1980, in reaction to the double-digit inflation rate.  FED chairman Paul Volker put a halt to the so-called stop-go monetary policy of frequent and unpredictable interest rate changes, and instead fought inflation with consistent, relatively high interest rates.  The result was that the U.S. economy continued to have its ups and downs, but inflation has stayed well below the double-digit range.  

Also, it was becoming clear that the FED was leaning in favor of its mandate to control inflation at the expense of full employment, which the FED interprets as an unemployment rate of between 4 and 5 percent. Presently, the FED feels that 2 percent “is most consistent over the longer run with its mandate for price stability and maximum employment.”  But maintaining such a tight leash on inflation has a high social cost. “There is very little basis in economic research for maintaining that a stable 3.0 inflation rate is more costly to the country than having 1 million people being needlessly unemployed,” wrote economist Dean Baker in 2015.  At that time, the actual unemployment rate, U6 in U.S. Bureau of Labor Statistics parlance, was at 10 percent, and the latest figures from February 2019 peg it at 7.3 percent.  During a recent meeting, the FED conceded that “it would not be appropriate to specify a fixed goal for employment,” but participants in the Federal Open Market Committee meeting estimated “the longer-run normal rate of unemployment was 4.4 percent.”

Of course inflation eats into the profits of bankers and financiers, and since the FED is composed of people who are either from the banking and financial services sector, or intend to have future careers in it, the policies adopted by the FED tend to be congruent with the interests of the banks and investment firms.  These are the types of people who are invited to the FED’s annual gathering in late August in Jackson Hole, Wyoming of bankers, policymakers, economists, academics and other influential people from around the world.  Last year’s symposium included such notables as Claudia M. Buch, Vice President, Deutsche Bundesbank; Andrew G. Haldane, Chief Economist, Bank of England; Agustín Carstens, General Manager, Bank for International Settlements; Stephen S. Poloz, Governor, Bank of Canada; Sylvie Goulard, Deputy Governor, Banque de France; Ilan Goldfajn, Governor, Bank of Brazil; Jing Liu, Deputy Representative, U.S Office of The People's Bank of China; and, Karnit Flug, Governor, Bank of Israel.  The absence of labor leaders or, for that matter, any representative of the common people leaves one gasping for breath.

In 2007, the first tremors of what was to be the worst economic crisis since the Great Depression of the 1930s were felt.  Homeowners who had taken adjustable rate mortgages (ARMs) began to default on their loans after the FED had raised interest rates, causing monthly mortgage payments to rise. The financial sector had created sophisticated financial instruments, mortgage-backed securities otherwise known as derivatives, from these mortgages to create investments.  The defaults on the mortgages rippled through to the derivatives causing their value to fall.  Likewise, as homeowners defaulted on mortgages, banks began foreclosing on homes, driving housing prices down.  

As the housing market crumbled, the FED began to cut interest rates in January 2008, and continued to do so feverishly until by December the target rate for federal funds was between zero and one-quarter percent.  In the meantime, the FED began to buy so-called toxic securities, primarily mortgage-backed securities that financial firms had purchased and could not resell due to the collapse of the housing market.  When the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), both quasi-governmental corporations created to expand mortgage accessibility, began to flounder under the avalanche of foreclosures, they were nationalized, giving them access to money from the U.S. Treasury general fund.

Over the decade from 2008 to 2018, the FED pumped some $4 trillion into the U.S. economy, which remains in an abnormal state, with historically low unemployment rates but uncharacteristically low inflation.  This $4 trillion appears on the FED balance sheet as assets, which, under the normalization program, were slowly being disposed of.  But due to economic concerns, such as the recent partial federal government shutdown, continued weakness in the housing sector and slowing global economic growth, particularly in China and Europe, the FED appears ready to normalize the abnormal: drop interest rates to zero and revive QE to resuscitate an ailing U.S. economy.

So it appears U.S. taxpayers will continue to be stuck with the bill for bailing out the “too big to fail” financial giants when their risky financial ventures go awry.  As economist Edward Kane noted, assurance of governmental rescue “permits aggressive managements to back risky positions” knowing there is a safety net of “equity capital extracted from hapless national or foreign taxpayers.”  Furthermore he stated, “Corruption deepens as the stakes rise and when incentive conflict tempts other players to join in a coalition to exploit taxpayers.”

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