Thursday, October 30, 2014

On the Federal Reserve’s Quantitative Easing: Impacts on the U.S. Debt and Inflation

With government-bond purchases of $3.9 trillion (including mortgage-backed bonds) from November 25, 2008 to October 30, 2014, the U.S. Federal Reserve Bank stimulated the American economy by keeping interest rates low. This in turn kept the U.S. Treasury department’s interest payments on the gargantuan federal debt lower than would have otherwise been the case. Put another way, the Federal Reserve Bank’s massive foray into stimulating the economy made holding debt and borrowing still more money less costly than it would otherwise have been, and thus enabled the government’s penchant for debt-financing over raising taxes and/or reducing spending. “Enabling an addict” would be a less charitable way of putting the Fed’s role vis-à-vis the U.S. Government. In this essay, I explore problems resulting from the Fed’s stimulus on the government’s debt-financing.
The central bank created the $3.9 trillion (less reinvested principal and interest payments received) out of thin air—increasing the number of dollars relative to economic output. The implied inflationary impact was hidden by the lack of demand-pull inflation during the recession and even the recovery, given the stationary income level and the relatively few new, full-time jobs created. Cost-push inflation was also low, with oil prices in particular dipping in 2014. In spite of Janet Yellen, the Fed’s chair, being worried more about deflation than inflation (as if years of piled-on low inflation should not naturally be balanced by years of low deflation), I am reminded of the interest-rate hikes that Fed chair Paul Volcker instituted in 1981 to squeeze years of high inflation out of the system.[1] Unlike cost-push and demand-pull inflation, more dollars chasing relatively less goods—even when the economy is growing—is bound to give rise to inflation at some point.
More troubling yet even more subtle, the Fed’s creation of dollars to buy treasury bonds means that the Treasury Department does not have to pay as much in interest as it otherwise would because the interest rates are lower. Congressional legislators and the president have in turn been more inclined than they otherwise would have to go the route of borrowing even more; for not only is the cost of borrowing less, they knew the Federal Reserve Bank would create money to buy treasuries. This feedback loop is inherently bad, both in terms of political economy and ethics.
First off, although the Federal Reserve is an independent federal agency, it is part of the federal government. Created by an act of Congress, the central bank can come to rescue of the U.S. Treasury Department but not those of the Union’s states (unlike the ECB in the E.U.). So a conflict of interest is exploited when a Fed chair decides to create money to finance (or lower the cost of) the government’s debt. Imagine what would happen if a person could create money to pay for food such as ice-cream and cake. It would be too tempting for the person to eat too much—his or her self-maintenance role would likely succumb to his or her pleasure-seeking role. Taking the Fed as federal institution, the conflict of interest lies in two or more such institutions, including the Fed, essentially colluding to get free (or reduced cost) debt. A scenario in which Congress and the president want to borrow $1 trillion and the Federal Reserve simply creates the money and sends it to Treasury.
One way the Federal Reserve can partially deconstruct the conflict of interest and reduce the chance of inflation is for the central bank to destroy rather than hold or reinvest the returned principal (and interest revenue less costs) when the bonds come due.[2] Ideally, all of the money that the Fed created for its Quantitative Easing program should be destroyed. To be sure, even temporarily creating money to buy treasuries makes it easier than would otherwise be the case for Congress and the White House to borrow. With an accumulated debt of around $17 trillion, the U.S. Government was already over-extended beyond the point of no return. For the Federal Reserve to create money to buy government bonds may only compound the quagmire even if the economy is stimulated in the short run. Examining these more subtle implications can thus potentially enhance the ability of the popular sovereign—the People—to keep the federal government from heading down a ruinous path.

[1] John Waggoner, “Easy Come, Easy Go: Beginning of the End,” USA Today, October 30, 2014.
[2] Darrell Delamaide, “A Pat on the Back for Yellen—But Lots of Hurdles Ahead,” USA Today, October 30, 2014.