The Fed has come in for a surprising amount of criticism since its decision in the fall of 2010 to launch a new round of monetary easing — Quantitative Easing 2. Ben Bernanke and his colleagues are right not to give in to these attacks.
Critiques seem to be of four sorts. (Some are mutually exclusive.)
1) “QE is weird.” Quantitative Easing entails the central bank buying a somewhat wider range of securities than the traditional short-term Treasury bills that are the usual focus of the Fed’s open market operations. This has been a bold strategy, which nobody would have predicted 3 or 4 years ago. But it has been appropriate to the equally unexpected financial crisis and recession. Some who find QE alarmingly non-standard may not realize that other central banks do this sort of thing, and that the US authorities themselves did it in the more distant past. It is amusing to recall that when Ben Bernanke was first appointed Chairman, some reacted “He is a fine economist, but he doesn’t have the market experience of a Wall Street type.” The irony is that nobody who had spent his or her career on Wall Street would have had the relevant experience to deal with the shocks of the last three years, since none of them were there in the 1930s. But as an economic historian, Bernanke had just the broader perspective that was needed. Thank heaven he did.
2) “Monetary easing under current circumstances has no effect.” It is true that, with short-term interest rates already near zero for the last two years, further monetary expansion is likely to be of less help than in a normal recession. (The classic “liquidity trap” has been re-born as the “zero lower bound.”) But monetary policy can work through other channels besides short-term interest rates. Seven such mechanisms are: long-term interest rates, expected inflation, the exchange rate, equity prices, real estate prices, commodity prices, and the credit channel. QE is worth a try, given that the economy is still weak and given the constraints that keep fiscal policy sub-optimal.
3) “Monetary ease will lead to inflation. What we need now, if anything, is monetary tightening.” This is the view, for example, expressed recently by some conservative economists, including John Taylor. It seems to me way off base. With unemployment far above the natural rate, GDP well below potential, and inflation (slightly) below target, it is clear that the Fed’s November 3 decision to ease further was appropriate.
4) “The Fed is firing a volley in a destructive international currency war.” This is the criticism that has come from some of our trading partners: in particular, China, Germany and Brazil. I don’t generally do “My country, right or wrong.” But my country is right on this one. Monetary easing is not a beggar-thy-neighbor policy. The colorful phrase “currency wars” seems to have confused some people. The current situation is precisely the point of floating exchange rates: when some countries feel that their high unemployment calls for monetary expansion (US) at the same time that others feel that their overheating calls for monetary tightening (Brazil, India, Korea, China…), an appreciation of the latter currencies against the former is precisely the way that floating rates accommodate the differences. This is why Milton Friedman favored floating rates, so that each country could pursue its own desired policies independently. I realize that the pressure which US monetary easing puts on countries like China to allow appreciation is unwelcome. China is finding it increasingly difficult to cling to its exchange rate target by means of controls on capital inflows and sterilized foreign exchange intervention. But capital flows are a far more legitimate way to let China feel the pressure than the alternative: Congressional threats to impose WTO-inconsistent tariffs on Chinese imports if it won’t allow faster appreciation of the yuan.
I was glad to see that today’s decision by the Federal Open Market Committee to stay the course was unanimous. The Fed is right not to give in to misguided criticisms. This is what we have central bank independence for.
Click here for a TV interview on today’s FOMC decision, and inflation & TIPs.
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