Free exchange | The Federal Reserve

QE, finitely

The Fed begins to taper its boldest and most controversial monetary policy

By G.I. | WASHINGTON, DC

JUST a few months ago it appeared Ben Bernanke would finish his eight-year term as chairman of the Federal Reserve without knowing whether his boldest and most controversial attempt to revive the economy was going to work.

That seems a little less likely now. On December 18th he and his colleagues announced the time had come to dial back its massive programme of buying bonds with newly printed money (dubbed quantitative easing, or QE). Investors responded euphorically, with blue-chip indexes soaring to records. Mr Bernanke said the programme was “well on its way to meeting our economic objectives” of putting the economic recovery on a path to sustained improvement. Whether that’s true won’t be known until well after he leaves office on January 31st, but for now the market seems to agree.

The Fed began its current, third round of QE in September of 2012 and unlike previous rounds, made it open ended—it would continue until the labour market’s outlook had clearly improved. But as growth proceeded in fits and starts, Fed officials and market participants began to fret: what if the economy never picked up? Would QE continue ad infinitum? Or would its unpleasant side-effects, such as asset bubbles, force its curtailment with its goals unachieved? Just last summer, as the economy flagged and Congress moved to shut down the government, Mr Bernanke passed up an opportunity to taper.

But then the tide, almost miraculously, began to turn. The pace of job growth increased, the unemployment rate declined (albeit in part due to a shrinking labour force), retail sales and manufacturing activity picked up. Congress declared a truce and passed a budget agreement that for the first time loosens the fiscal vise, albeit modestly, and foreign economies showed signs of momentum. Even housing, which wavered as mortgage rates shot up in anticipation of tapering, did not crumble, and indeed housing starts in November hit a post-recession high.

Mr Bernanke didn’t declare mission accomplished by any means. QE will continue, only more slowly; starting in January, the Fed will trim its monthly pace of bond purchases from $85 billion to $75 billion. Thereafter the Fed “will likely reduce the pace of asset purchases in further measured steps at future meetings.” Speaking to reporters afterwards, Mr Bernanke said he expected QE would come to a halt by late next year, but he emphasised this was contingent on the economy doing as the Fed expects. That means growth of about 3% and a fall in unemployment to around 6.5% in 2014 (the Fed’s latest economic projections are here). If it does worse, tapering would halt; better, and it would quicken.

More important, tapered QE was coupled with a stronger commitment to keep the short-term interest rate target at zero. The Federal Open Market Committee (FOMC) had previously said it would stay at zero at least until unemployment had fallen below 6.5%. On Wednesday it said it would stay there “well past the time” that unemployment drops below 6.5%, “especially if projected inflation continues to run below” its 2% target. That, according to FOMC members’ projections, means until 2015 or later.

It is entirely possible that the tapering decision will prove premature. The Fed terminated two previous rounds of QE, only to restart them when the economy faltered and deflation fears flared. The FOMC’s forecasts have repeatedly proved too optimistic. Two years ago it thought GDP would grow 3.2% in 2013; a year ago, that had dropped to 2.6%, and it now looks to come in around 2.2%.

Moreover, inflation has, disturbingly, slid to around 1.5%; the FOMC expects little increase next year. Low inflation is both a prelude to actual deflation, and troublesome in itself. If households come to expect inflation to stay low, then real interest rates rise, holding back demand. QE is important as a signal about the FOMC’s thinking, not just for what it does to the economy. Thus, the decision to taper could yet be interpreted as passive acceptance of lower inflation. One official, Eric Rosengren of the Boston Fed, dissented from the tapering decision, citing both high unemployment and below-target inflation.

Mr Bernanke indicated he thought the drop in inflation was due to transitory factors, such as a slowing rise in health costs, and that it would drift back to 2%. Whether a failure to do so would cause QE to be ramped up again is unclear, but it would certainly result in a much longer period of zero interest rates. The bottom line is that an improving path for growth figured more prominently in the Fed’s thinking than the declining path of inflation.

Whether that will prove the right trade matters not just for the economy but for Mr Bernanke’s legacy. Asked to reflect, Mr Bernanke said future monetary historians would be most interested in the Fed’s creative response to the crisis in 2008 and its subsequent use of QE and forward guidance to overcome the shackles of zero interest rates. Uncharacteristically for those in high office in Washington, he even acknowledged errors: “We were slow to recognise the crisis; I was slow to recognise the crisis. In retrospect, it was a traditional, classic crisis, but in a very, very different guise, different types of financial instruments, different types of institutions which made it for an historian like me more difficult to see.”

Yet most monetary experts have already given Mr Bernanke high marks for his handling of the crisis. Where they must likely withhold judgment for years yet is on how he handled the aftermath. Did he pursue a sufficiently creative monetary policy to restore employment? Was he too aggressive, storing up trouble in the form of financial imbalances or inflation in later years? Asked, Mr Bernanke said, “I hope I live long enough to read the textbooks.”

(Photo credit: AFP)

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