Risks from the New Fed Policy

As I mentioned in my last post, the Fed's announcement that it will more aggressively expand the monetary base is a much needed development. Without it the dramatic collapse of U.S. nominal spending will only get worse and further destabilize the U.S. economy. This move can be viewed as an attempt to prevent the U.S. economy from overshooting on the downside, a policy objective that even Frederick Hayek supported. With all that said, there are risks associated with this policy move. First, Caroline Baum reports this new policy, which purposefully targets long-term Treasuries, may create big distortions in the market for Treasuries. Second, this aggressive monetary expansion will eventually have to be reversed to avoid a repeat of the 1970s-type inflation. This reversal, however, may not be politically popular if it involves some pain as noted by John Taylor:

Will the Fed be able to change course in time? To do so, it will have to undertake the politically difficult task of getting more than $3,000bn of government securities, private securities and loans off its balance sheet.

Given the short-run real effects of monetary policy, a reduction of the money supply of this size could be very disruptive. The reversal also may involve some quasi-fiscal costs as noted by Paul Krugman:

But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.In short, unwinding this aggressive expansion of the money supply may not be easy.

Given the possibility of these politically sensitive developments, one could question whether the Fed will actually be able to reverse itself in the future. This is a real concern, but as pointed out by Tim Duy the Fed and U.S. Treasury released a statement yesterday reconfirming the Fed's independence. Hopefully, this statement gives the Fed the freedom to take do what is needed to stabilize nominal spending presently without jeopardizing its independence in the future.