Oxstones Investment Club™by Jeremy Siegel, Ph.D., Yahoo Finance,
One of the most gratifying experiences of my career was being a colleague of Milton Friedman’s at the University of Chicago. This was my first academic position after receiving my Ph.D. in economics from MIT. Not only had Professor Friedman’s political philosophy attracted me but he was also the acknowledged expert in monetary policy, which was my specialty. Friedman’s path-breaking analysis of the Federal Reserve’s failure to provide liquidity to the banks as a cause of the Great Depression was cited as one of the reasons he was awarded the Nobel Prize in 1976.
After Friedman retired from teaching and moved to San Francisco, I visited him and his wife, Rose, as often as I could. I particularly recall a meeting with him in 1997 at his summer home in Sea Ranch, about 100 miles north of San Francisco. I asked him what the Japanese could do to help their economy, given that the Bank of Japan had reached zero short-term interest rates.
He replied without hesitation, “Add more liquidity to the system — create more reserves!” He reiterated a major theme of his monetary research — that one should not look at interest rates when judging the stance of monetary policy but at liquidity, reserves, and the supply of money.
Friedman died in 2004, several years before the recent financial crisis. The absence of his perspective on the Fed’s monetary policy is sorely missed, but I have no doubt that he would have stood foursquare in favor of the quantitative easing now pursued by Ben Bernanke.
Reasons for Quantitative Easing
The Lehman bankruptcy in September 2008 set off the biggest liquidity shock to the U.S. financial system since the 1930s. Corporations, investors, and particularly banks rushed to hold large quantities of safe, liquid assets even though their yield went to zero. The Fed halted a credit collapse by providing more than $1 trillion of excess reserves to the banking system and temporarily insuring the money market funds and bank deposits. This provision of reserves was the first quantitative easing. Had it not occurred, banks would have called in loans and sold investments to meet liquidity requirements, sending financial markets much lower.
Nevertheless, the desire for liquidity was so large that, while the Fed’s provision of excess reserves stopped the contraction of credit, it did little to induce banks to lend. That is the goal of QE2, the second quantitative easing now being pursued by the Federal Reserve. By providing more reserves to the banking system, the Fed expects banks to coax some of these additional reserves, which are now earning very little interest, into a much more lucrative loan market.
Interest Rate Not Right Indicator
Less than a month after the Fed announced its plans to buy more Treasury securities, some observers are already calling QE2 a failure. Since the November 3 meeting, long-term interest rates have risen almost 50 basis points and are even higher than they were when Bernanke first hinted at a QE policy at the Fed’s monetary conference in Jackson Hole last August.
But looking for a decline of long-term interest rates to judge the success of QE is incorrect. In fact, an increase in long-term rates is indicative of the success of quantitative easing, not its failure.
The reason for this counterintuitive result is that long-term interest rates are set by expectations of the future course of the economy and inflation. The actual buying of government bonds by the Fed by itself has only a very small impact on their price. Even the Fed’s planned $600 billion purchase of long bonds over the next nine months will scarcely offset the new supply of those bonds floated by the Treasury to fund our huge federal deficit.
The impact of quantitative easing comes through its effect on the supply of reserves and therefore lending and deposit creation, not interest rate reductions. If QE is viewed as effective at stimulating the economy, then long-term rates will rise, not fall, in response to the Fed’s policy.
The impact of open market purchases on long-term interest rates stands in stark contrast to its impact on the short-term, Federal Funds rate. Federal Funds are an overnight loan between banks and are influenced only by the supply and demand for liquidity over the next 24 hours. As a result, open market operations will always decrease the Fed Funds rate, but no such conclusion can be made on long rates.
Variables to Watch
If we cannot use long-term rates to judge the success of quantitative easing, how can we tell if QE is working? We can look at the dollar, commodity prices, but most important, the money supply and quantity of loans issued by the banking system. If we see those variables increase, we know that the increase in reserves is finding its way through the monetary system.
By the way, it was extremely wise that the Fed chose not to peg the interest rate on long-term bonds as was suggested by some at an unusual teleconferencing meeting held on October 15. Bernanke knew that such a policy could be destabilizing, as the Fed might be required to purchase more bonds than it planned if a recovering economy sent interest rates higher.
Quantitative easing is the right policy for the Fed to follow. It was the rush to liquidity that precipitated the financial crisis two years ago and it will be the provision of liquidity that will speed the economic recovery now. Those who cite the rise in interest rates as a justification for criticizing the Fed’s current monetary policy have a fundamental misunderstanding of what should be expected from quantitative easing.
Tags: bank lending, big picture, commodity prices, counterintuitive result, dollar, excess reserves, food for thought, growing economy, indicators, inflation, liquidity, Money Supply, Quant Easing, rising interest rates, velocity of money