Economics 101: It’s not a nail

It has been said before that when the only tool you have is a hammer, every problem looks like a nail. From THE WALL STREET JOURNAL:

No Surprise as Fed Keeps Rate Stance

By Jon Hilsenrath and Victoria McGrane | Updated January 30, 2013, 7:09 p.m. ET

The Federal Reserve is keeping its foot pressed firmly on the monetary gas pedal amid news that the economy essentially stalled late last year.

Fed officials decided Wednesday, at the conclusion of their first policy meeting of 2013, to keep purchasing $85 billion a month of mortgage-backed and Treasury securities and signaled no intention, for now, to let up.

The policy, known as quantitative easing, or QE, is meant to hold down long-term interest rates and encourage more spending, investment and hiring. But critics, including some within the Fed, worry it could cause higher inflation or new financial bubbles.

The Fed repeated that it will keep buying bonds until the jobs picture improves substantially.

It also reaffirmed its commitment to keep short-term rates near zero until unemployment drops to 6.5% from the current 7.8%. That depends on inflation holding to within a half percentage point of the Fed’s 2% target.

More at the link.

The very obvious question to be asked of the Fed’s “quantitative easing” program is: has it worked? Chairman Ben Bernanke and the Federal Reserve Board of Governors have been using quantitative easing for a while now, for one simple reason: it’s just about the only tool they have left. The interest rates the Fed directly controls, the Federal Funds Rate and the Discount Rate, are very low and the Prime Interest Rate, which the Fed does not directly control, is currently a very low 3.25%.1

Quantitative easing is not a program to further reduce short-term interest rates, but to get longer-term rates lower. The risk of that, as noted in the JOURNAL original, is inflation. If you’ll refer back to the story from earlier this evening, Karen and the Obama economy, as well as Karen’s story concerning material price increases for her family business, you’ll see that the inflation is already there — just not officially — yet what the Fed is trying to achieve, greater economic growth and job creation, just isn’t being produced by the current policies.

It’s not difficult to see why: businesses invest in new plant, equipment and workers when they can reasonably see2 an increase in demand for their products which would justify an increase in their productive capacity. If there is no reasonable expectation of increased profitability from increasing productive capacity, it makes no sense to invest in increasing productive capacity, a risky endeavor, no matter how low interest rates are!

That shouldn’t be a difficult economic concept. Chairman Bernanke holds a PhD in economics and was a full professor at Princeton before he went into government; he knows that fact as well as anybody else, certainly as well as your Editor. Dr Bernanke spoke about the so-called “Great Moderation,” a “reduction in the volatility of business cycle fluctuations starting in the mid-1980s, believed to have been caused by institutional and structural changes in developed nations in the later part of the twentieth century,” which reduces the effectiveness of macroeconomic policies. Yet the Chairman and the majority of the Federal Reserve Governors continue to use quantitative easing, despite the risks of inflation, because it is the only tool that they have left. It hasn’t worked, it isn’t working, but given a choice between using the only tool that they have left and doing nothing, their bias is to keep on plugging along; the notion that maybe, just maybe, they ought to try doing nothing seems to be outside their paradigm.

So, the Fed is going to keep going, keep trying to force interest rates lower — not that they can realistically get much lower — when the problem isn’t that interest rates are too high, but that few people with any reasonable creditworthiness sees any real reason to borrow money for business expansion.

  1. The link given will give you the current interest rates; the rate cited was current as of Wednesday, 30 January 2013.
  2. This is as much an art as a science, and not every businessman gets it right.

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