Economics

Should the Fed reverse its loose stance?

According to Ben Bernanke, the Chairman of the Federal Reserve Board, the pulling back on aggressive policy measures too soon would pose a real risk of damaging a still-fragile recovery.

The Fed Chief is of the view that for the purposes of financial stability a continuation of the central bank’s aggressive stimulus conducted through purchases of Treasury and mortgage securities remains the optimal approach.

In response to the financial crisis and the deep recession of 2007-9, the Fed not only lowered official rates to effectively zero, but also bought more than $2.5 trillion in assets in an effort to keep long-term rates low.

But is it true that a loose monetary stance provides support to economic activity? Furthermore, if this is the case then why after such an aggressive lowering of interest rates and massive expansion of the Fed’s balance sheet does the economic recovery remain fragile?

Surely if loose monetary policy could revive economic activity then a very loose policy should produce very strong so called economic growth – so why hasn’t it happen this way?

Contrary to popular thinking, loose monetary policy, which leads to a misallocation of resources, weakens the economy’s ability to generate final goods and services, i.e. real wealth.

This means that loose monetary policy not only cannot provide support to the economy but on the contrary undermines the foundations for economic growth.

The so-called recovery that Bernanke and most commentators are referring to is nothing more than the revival of various non-productive or bubble activities, which in a true free market environment wouldn’t emerge in the first place.

These bubble activities are funded by means of loose monetary policies, which divert real wealth from wealth generating activities thereby weakening the process of wealth generation.

From this we can infer that a still fragile economic recovery, i.e. a fragile revival of bubble activities, despite the very loose Fed monetary stance could mean that the wealth formation process must have been badly hurt. (Note that notwithstanding very loose monetary policies, without the expanding pool of real wealth it is not possible to stage a strong recovery of bubble activities).

If our assessment is valid then obviously the sooner the loose stance is reversed the better it is going to be for the economy.

Needless to say, bubble activities are not going to like this since the diversion of real wealth to them from wealth generators will slow down or cease all together.

A fall in economic activity in this case is in fact the demise of various bubble activities.

Contrary to Bernanke, we can conclude that the continuation of loose monetary policies could only lead to financial instability and prolong the economic crisis.

Some commentators, among them Bernanke himself, blame the fragile economic recovery on banks’ reluctance to aggressively lend out the money pumped by the Fed. Without the cooperation of banks, the Fed’s aggressive pumping is not translated into a strong expansion in the money supply.

On this the growth momentum of commercial banks lending shows softening. Year-on-year the rate of growth of real estate loans fell to 0.1% in February from 2.3% in the month before.

The yearly rate of growth of business loans eased to 11.3% last month from 13.5% in January.

Also the growth momentum of commercial banks consumer loans has eased last month. The yearly rate of growth softened to 3.8% from 3.9% in January.

The pace of overall commercial bank lending, which includes lending to government, has eased visibly last month. Year-on-year the rate of growth fell to 3.7% from 6.2% in January.

The growth momentum of inflationary lending remains in a visible decline with the yearly rate of growth closing at 6.2% in February from 11.3% in January.

The banks’ reluctance to lend is also seen in the strong increase in their holdings of surplus cash. In the week ending March 6 excess cash reserves stood at $1.648 trillion against $1.546 trillion in March last year and $0.8 trillion in January 2009. Also note that in the week ending March 6 the yearly rate of growth of Fed’s balance sheet jumped to 7.6% from 4.7% in February.

Once the pool of real wealth comes under pressure, the number of good quality borrowers tends to decline. Obviously this tends to reduce the supply of lending. We suggest that if the pool of real wealth is stagnant or worse declining then regardless of whether banks will start lending or not, no meaningful economic expansion can emerge.

Summary and conclusion

According to the Fed Chairman Ben Bernanke pulling back on aggressive policy measures too soon would pose a threat to economic recovery. Our analysis indicates, however, that the sooner the Fed reverses its loose stance the better it is going to be for the underlying fundamentals of the US economy. A reversal in the current loose stance, whilst good news for wealth generators, is going to undermine various non-productive wealth consuming activities. Meanwhile the growth momentum of US commercial bank lending displays a visible weakening.

13 comments to Should the Fed reverse its loose stance?

  • Captain Skin

    Must be getting close to the crack-up now…

  • Andy V

    As asinine as central banks are, and of course everyone believes they should be exterminated, I’m not going to put all the blame on Bernanke. The US economy is perfectly capable of recovering itself, banks are saturated in cash, there is an abundance of workers. A staggering $21tn or even more is believed to being kept hanging around in tax safe havens by businesses now. Banks have money, business has money and you have a willing available workforce. The only 2 people who can help get the economy going are banks and business, none of this should be complicated, so why is the economy not going anywhere?
    Business will tell you they have no confidence in Obama; more legislation, more anti business rhetoric, taxes and interference makes it impossible to go forward in making an investment, everyone stands still. This is exactly the same slow down you had when Hoover and FDR wrecked the economy, contrary to popular belief that the New Deal saved the economy, which is not even remotely true.
    Flogging central bankers is necessary, but they aren’t the only variables in the sphere of influence.

  • The real problem is that any central bank monetary policy is going to be wrong, and the problem with the present CB policy is not that it is loose, so much as impotent.

    “Contrary to Bernanke, we can conclude that the continuation of loose monetary policies could only lead to financial instability and prolong the economic crisis.”

    IOW, the continuation of ineffectiveness can never achieve effectiveness. In a bubble-bursting downturn, CB monetary policy amounts to pushing on the interest rate string, ostensible to restore commercial activity. But it is impossible to overcome economic inertia by driving up bank reserves, especially when the policy includes paying a return on these excessive reserves.
    Those are the headwinds to policy success, and they are inherent to the policy.
    Under the present system of debt-based money, CBs are pretty much powerless to get the old velocity of money moving forward.

  • Paul Marks Paul Marks

    The policy of “cheap money” has failed – failed in Japan, failed in Britain and failed in the United States.

    However, the failure in the United States is partly obscured by the boom in oil and gas production (which, ironically, the government did all it could to PREVENT).

    Less expensive energy and the profits from oil and gas production have created some real (as opposed to pure credit bubble) growth in some areas of the United States.

    But it will not be enough.

    The twisting of the capital structure (by the endless Fed money) will destroy the American economy.

    Just as Central Bank “cheap money” is destroying other nations.

  • Gary

    Qe is a one way street bounded by a dead end. The low rates become a trap from which there is no escape without pain or catastrophe.

  • Why does everyone assume that interest rates are low compared to what they’d be absent any form of government influence on rates? Given the VAST amounts borrowed by government over the last few decades or even centuries, it’s perfectly arguable that for most of that time interest rates have been HIGHER than would obtain in a free market – with the recent drop in rates being a return to something nearer free market rates.

    Second, Frank Shostak’s article is naïve in that he assumes that Bernanke means what he says. The reality is that central bankers speak in code more often than not.

    My guess is that he is perfectly well aware that easy money has a limited effect, as may become apparent if and when he writes his autobiography. But what else is he supposed to do? He knows, as does only with half a brain, that Congress is more interested in in-fighting that solving America’s economic problems. But he can’t sit on his hands doing nothing. So he implements easy money, knowing full well that it will have only a limited effect.

    I look forward to reading his autobiography.

    • Gary

      Rates must be lower than what they would be if there was no QE, otherwise why do QE ? And given that , how do you stop QE without rates rising and wiping out all the debt that was acquired at the artificial rates caused by QE ? Not to mention prior to QE, rates were pinned down for years by the cheap credit bubble. We have an entire economy , mostly malinvestment that probably cannot remain alive at a higher cost of funding , built on funding from artificially low rates. How do you back out of that without extreme damage ?

      • Re your first sentence, I agree that rates must be lower than had there been no QE. But the actual AMOUNT by which QE will have reduced rates will be minimal. Remember that the whole objective of QE is to give some sort of monetary stimulus when rates are already so low that they can’t very much lower. That’s what lies behind the word “quantitative” in QE. I.e. the effect is supposed to make bigger VOLUMES of money available to borrowers without there being much effect on the PRICE that borrowers pay for money.

        Re the “malinvestment” to which Austrians keep referring, I always think they over-do that point. I’m not in favour of governments manipulating interest rates. However even if governments do raise or lower rates by 2 or 3%, remember there are a string of other costs involved in investments: associated labour costs, depreciation, energy consumption, etc. In short, if interest rates are two or three percent higher or lower than they’d be in a pure free market, I don’t think one gets a HUGE excess or deficiency in investment.

        • Gary

          I am no expert on bond valuations, but if mathematician and economist Prof Antal Fekete is to be believed, then the rates and the value of the bonds have a proportional and inverse relationship. So, if you 1/2 the rate on the bond you double the value of the bond. When rates are near zero you only have to move the rates a small amount to get a large correction on the bond value. Slashing rates from 1/2% to 1/4% doubles the value of the bond, and vice versa. In the secondary markets , of course. These large swings will cause havoc in the present value calculations of future cash streams. A sharp move of rates from 0.25% to more historic average 5% , as I expect to happen if QE is stopped, will unleash large ructions in the markets. For one the property market will collapse , the banks in the derivatives markets based on property will probably collapse(counter-parties will become insolvent), and the Central Banks’ balance sheets will collapse. Those three events alone will probably do for the economy.

          • Gary

            BTW : apologies for replying to myself, I forgot to add that virtually the entire economy being tied up in one way or another to the property market , is an stark example of how artificially low rates caused malinvestment in this sector , with grave consequences.

  • Paul Marks Paul Marks

    Ralph Musgrave makes a valid point.

    If there was no more government borrowing, and (on the other hand) no Bank of England monetary expansion – we do not know for certain what the level of interest rates would be.

    We may suspect that interest rates would be higher – but we do not KNOW for sure.

    After all – prices would dramatically drop (with the collapse of the credit bubble financial system).

    We would have to wait for the establishment of a NEW fiancial system (after the collapse of the present credit bubble one) to see what would happen.

    Obviously DURING the collapse a saver would be very unwise to have his or her savings in a bank or other such.

    There is no way that the present fiancial structure can be saved – it is too distored.

    And there is no way that a lot of suffering can be avoided during its collapse – things have gone too far for that.

    But what will come in its place?

  • chuck martel

    And there is no way that a lot of suffering can be avoided during its collapse

    That, too, is as it should be. It will require a lot of suffering for people to realized that the fiat money, central bank paradigm is no service to humanity. Attempting to prop up the rotting edifice that is the international financial system is a waste of energy doomed to failure. Let it crumble and then, perhaps, the hoi polloi will realize that a free market, in both goods and money, is the proper course. Naturally, in a generation or so, the stern lesson will be forgotten and life’s losers will demand intervention on their behalf by the omnipotent state. Such is the cycle to which mankind is doomed.

  • Paul Marks Paul Marks

    Chuck Martel – it will be very hard on people and they may not be able to take it.

    To give a light hearted example of what I mean – there was an old hammer horror film where the hero is asking why they must destroy someone who has been biten by a vampire.

    “But I survived the vampire’s bite” (i.e. the hero did not turn into a vampire).

    “He was not a man such as you” is the reply.

    People are no longer Stoics.

    They can not take suffering – they often become like rabid animals blaming everything on “the rich” (or whatever).

    The cultural decay (that became obvious in the 1960s (but actually goes back long before – and was long WORKED for) had taken its toll.

    We are not only in for hard times – we are in for VIOLENT times also.

    There is the stink of Latin America over much of Europe and parts of the United States – a deluded mob mentality.

    Ralph Musgrave…..

    As has been pointed out by others.

    Most “investment” in Britain and the United States is either credit bubble stock market activity, or the (government pushed) house building stuff.

    It is indeed MALinvestment.