Business Times - 02 Nov 2010
Fed set to fire up monetary engine
By LEON HADAR
IT IS appropriate that the decision to launch another round of monetary stimulus by the US central bank is going to be made the day after the midterm congressional elections. At a time when the majority of Republican lawmakers as well as many Democrats are opposed to the introduction of even the most modest fiscal stimulus programme, it is Ben Bernanke, the chairman of the Federal Reserve, and his colleagues on the institution's policy-making body who are being forced to 'do something' to re-energise the sluggish economic recovery.
If anything, with the Republicans increasing their strength in the newly elected Congress - thanks in large measure to the support of the fiscally ultra-conservative members of the Tea Party - the chances that US lawmakers would back even a short-term stimulus package are close to zero. Most opinion polls suggest that a majority of Americans have concluded that the US$787 billion stimulus bill aka the American Recovery and Reinvestment Act that Congress approved last year failed to, well, stimulate the economy and create new jobs, and that the voters are opposed to new stimulus packages.
In fact, much of the successful Republican election campaign, driven by the Tea Partiers, centred on the Republican's message that not only had the stimulus package failed to do any good for the economy, but that it had also expanded the ballooning US federal deficit to the stratosphere in a way that could threaten American long-term economic security.
Hence the current consensus in Washington is that President Barack Obama and Congress need to focus on ways to cut spending and reduce the deficit - perhaps along the lines of the austerity programme being pursued by the British government. Although some economists continue to argue an activist fiscal policy is still necessary in order to revive demand and create new jobs, Keynesian principles are not 'in' any more in Congress.
But then with a meek economic growth and an unemployment rate wavering around 10 per cent, the hope in Washington and on Wall Street is that a rerun of the Fed's injections of millions of dollars into the American economy aka 'quantitative easing' (QE2) - the Fed going into the markets and buying all of long-term securities, primarily Treasury securities - could substitute for a lack of action by the politically paralysed administration and Congress and help stimulate the economy through another set of quantitative easing or QE2.
The theory behind quantitative easing is quite simple: The Fed's action is going to put downward pressure on long-term interest rates, which will encourage companies and small businesses to borrow money and expand which, in turn, stimulates the economy and leads to more hiring by the private sector.
But the danger is that quantitative easing - which is basically printing money - could be putting upward pressure on inflation and diluting the value of the US dollar. But the current rate of inflation is getting close to zero and deflation seems to pose more of the threat to the economy.
In that context, it should be recalled that historically Congress directed the Fed to implement policies designed to balance the two goals of low inflation and full employment. And since, as noted, inflation is currently very low and unemployment is very high, it seems that the Fed's duty is to use its power to reduce unemployment by stimulating the economy.
From that perspective, quantitative easing allows the Fed to contain deflationary pressures and increase the monetary supply by making funds available at lower than zero interest rates.
But it is not clear that a QE2 will help achieve the goal of accelerating the growth in the economy and increasing employment. In fact, the unemployment rate continued to rise even as the first round of quantitative easing (QE1) was being pursued by the central bank. But Fed officials when discussing the success of the QE1 make the same point that the Obama administration makes with regard to the fiscal stimulus package - that without the QE1, things would have been worse.
But even under the best-case scenario, no one really expects the QE2 to have any major effect on economic growth and the unemployment rate next year. The White House and Congress will eventually have to 'do something' if they want to avoid the worst-case scenario of anaemic growth, continuing deflation and high unemployment.
Interestingly enough, The New York Times reported recently that Mr Bernanke himself has concluded that the politicians in Washington need to embrace an activist fiscal policy in the form of a mix of short-term fiscal support for the economic recovery and a long-term strategy to reduce the deficits. In short, even the most innovative and aggressive monetary policy by the Fed is not going to be a substitute for an effective fiscal policy.
Unfortunately, it is not clear that the US lawmakers have the political courage to do that.
Copyright © 2010 Singapore Press Holdings Ltd. All rights reserved.