The Fed and Unintended Consequences


By Dr. Lynn Reaser

Last week, Federal Reserve policymakers voted to leave their primary monetary policy lever, the federal funds rate, in a target range of 0 to 1/4 percent and suggested that this target will be maintained for an “extended period.”  With unemployment still high and inflation low, most of the policy officials are probably not contemplating an interest rate hike until perhaps the latter part of 2011 or beyond.

More importantly, with only one dissent, the policy-setting body voted to hold the size of its balance sheet constant by not allowing any of its $2.1 trillion of securities to run off.  The Federal Reserve now holds about $0.8 trillion of Treasury bills, notes, and bonds and $1.3 trillion of debt either issued or guaranteed by government agencies (Fannie Mae and Freddie Mac).  Prior to its massive relief effort launched as the financial crisis escalated in fall, 2008, Federal Reserve security holdings totaled less than $500 billion with holdings limited strictly to Treasuries.

The intent of last week’s policy announcement was to prevent monetary policy from becoming more restrictive through a shrinkage of its balance sheet, which would otherwise take place as various securities matured.  The proceeds will now be reinvested in Treasury notes with maturities of two to ten years. 

Federal Reserve policymakers might have hoped that financial markets would interpret this as a “pro-growth,” strategy.  Instead, the dominant reaction was a new sense of concern over economic prospects.  If the Federal Reserve had now turned much more bearish on the economy’s outlook, why should investors think differently?  In response, stock prices dropped substantially, interest rates fell, and the dollar rallied as a “safe haven.” 

The attempt of policymakers to avoid tightening in a period of economic slowing might be justified, although it is not clear how serious or prolonged this slowing might be.  In any case, the decline in stock prices and rise in the dollar’s value may have cancelled the stimulative effort.  Lower stock prices represent a tightening in financial conditions by raising the cost of equity capital while also reducing household wealth.  A stronger dollar could reduce U.S. export potential.

The new balance sheet strategy could also have an adverse longer term impact.  First, it represents a monetization of the federal debt, which could delay some of the pressure to address our fiscal imbalance.  For businesses and consumers, that would likely mean higher interest rates down the road.  Second, it could spawn a new wave of excessive risk taking, such as helped drive much of the last financial crisis.  Already the “junk” or high-yield bond market has seen a resurgence of activity.  This means that another bubble could eventually develop with its inevitable negative repercussions.  Third, it could make the eventual “exit strategy” by the Federal Reserve from an aggressive support and intervention into credit markets even more difficult.  This could cause monetary policy to be too easy for too long, ultimately pushing inflation to higher levels.

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