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On 60 Minutes last night, Fed Chairman Ben Bernanke defended the Fed’s activism in buying more Treasury bonds, but he wasn’t compelling.
The issue is that the Fed is expanding to over $3 trillion in assets, a step it should only consider if there were a dire threat to the financial system that buying more bonds, so-called quantitative easing, would fix.
Bernanke didn’t claim an emergency. He said a double dip was unlikely because many parts of the economy are still operating at a low level.
Having the Fed buy bonds in the absence of a crisis is unprecedented and raises many risks – it manipulates markets, creates a bigger overhang when the Fed tries to unload the bonds, risks capital losses at the Fed if interest rates rise, and puts taxpayers and the dollar at risk by shortening the maturity of the outstanding national debt.
Bernanke didn’t claim that the Fed action was helping small business or that it would create jobs. He said the Fed’s goal is simply to lower interest rates on bonds.
This won’t help private sector jobs. The Fed is buying government bonds. In theory, this lowers the government's interest rate -- though in practice they’ve gone up -- at the expense of savers. It might hold down the interest rate some on big corporate bonds, which are tied to Treasury bonds. But few net jobs are created at companies big enough to issue bonds – most jobs come from new small businesses. Even if the Fed succeeds in lowering the interest rates for big companies a little, that would hurt savers.
The Fed’s case for QE is simply an insufficient rationale for a major expansion of the Fed.
The interview sounded over-confident in two areas. Bernanke said that the Fed is “using its own reserves” to buy bonds. This makes it sound as if the Fed already has the money to start with. The reality is that the Fed borrows from banks to buy Treasury bonds. The Fed's increased assets (the bonds) are matched by an increase in liabilities (the increased amount it owes to banks.) The Fed and the taxpayer are at risk because the Fed is borrowing short-term from banks to lend long-term to Treasury.
In addition, Bernanke said that he is 100% confident in the Fed’s ability to hold inflation to 2% and “inflation is not a problem because we could raise rates in 15 minutes.” That’s not a good choice of words given the Fed’s experience in the last decade with over 5% inflation and its difficulty finding the resolve to raise interest rates even in the face of a crashing dollar. Inflation is a delayed reaction to monetary policy that would be very difficult to keep in a narrow range even if the Fed had a single price-stability mandate and admitted the connection between a weak dollar and inflation. Bernanke hurt his case by overstating the Fed’s inflation powers and ignoring its history.
In sum, the Fed is expanding at the wrong time from the standpoint of both economics and politics. The added bond holdings will complicate the exit strategy. The Fed is undermining its credibility by appealing to the public and, in the 60 Minutes interview, through over-confidence. The more it talks, the clearer the risks. The cost of weakening the Fed’s credibility would be worth it in an emergency, but isn’t under present economic circumstances.
In the interview, Bernanke left open the possibility that the Fed might buy more than the $600 billion already planned. He wasn’t asked whether the Fed might buy less than $600 billion, a clear possibility in the November FOMC statement. The best course would be for the Fed to claim victory – citing the improvement in financial markets in September and October and Bernanke’s 60 Minutes view that there’s not much risk of deflation – and wind down its bond purchases.