Don't Fight the Fed

Only time will tell if QE2 is effective.

January 1, 2011

“There have been three great inventions since the beginning of time: fire, the wheel, and central banking,” Will Rogers once said.

This economic wit is being put to the test with the announcement in November that the Federal Reserve intends to purchase $600 billion of longer-term Treasury securities through June 2011, in an attempt to strengthen a weak economic recovery.

This new “quantitative easing” policy is set against an economic backdrop of already low interest rates, strong global growth, business risk aversion, and upward momentum of the business cycle. The Fed believes this second round of quantitative easing, or QE2, is a necessary condition to support a fragile recovery, and a way to prevent disinflation from becoming deflation.

The Fed believes that by pushing longer-term interest rates down, they’re creating the necessary conditions for faster economic growth, but not the sufficient conditions. Sufficient conditions for faster growth would include jumps in business and consumer confidence levels, or what economist John Maynard Keynes would have called “animal spirits.”

QE2—or “monetization of Treasury debt” as economist Milton Friedman would have called it—is supposed to lower interest rates and the value of the dollar, and increase stock prices and inflation expectations. These four effects, in theory, should increase consumer spending, business investment, and foreign spending on U.S. exports.

Here’s how QE2 could affect credit union operations and financial performance:

• The Fed likely will hold nominal interest rates below the inflation rate for the next two years. Credit unions should position their balance sheets to adapt to this low-rate
environment. Lower rates will also help firms and households repair their balance sheets, through refinancing existing debt. Refinancing activity, however, will place downward pressure on credit union asset yields, and ultimately on net interest margins.

• Investments with annual yields lower than 1.25% will face a negative real return if inflation, as expected, runs around 1.25% over the next two years. Based on the yield curve at press time, that means investments with maturities of less than four years are guaranteed to lose purchasing power during the next couple of years.

• Lower long-term Treasury interest rates will keep 30-year mortgage interest rates low. Your credit union should be able to maintain a healthy level of mortgage refinances, and members’ balance sheets and cash flows should improve. This, in turn, should improve loan delinquency and charge-off rates, which will help lower loan loss provisions and boost credit unions’ bottom lines. Moreover, as the economy recovers, the lower mortgage interest rates coupled with further job creation will stimulate purchase-mortgage applications.

The Fed’s determination, however, to avoid deflation by implementing QE2 could actually cause deflation. Some interpret QE2 as a sign the Fed expects underemployed resources for an extended period. This could increase private sector pessimism as firms expect investments to fail and households expect prices to fall. Both would hoard cash, weakening the economy and creating deflation. The Fed decided against a more aggressive QE2 to avoid signaling to investors that the Fed was panicking.

Central bankers and finance ministers from around the world aren’t pleased with QE2. They’ve questioned the Fed’s wisdom—calling it “reckless” and “feckless” (the latter meaning ineffective, incompetent, futile, or having no sense of responsibility).

Critics believe lower U.S. yields will only chase capital abroad, appreciate foreign currencies, and amplify global economic distortions. This could lead to competitive quantitative easing, whereby other countries compete by printing more money to reduce their exchange rates and boost their exports.

Low interest rates are intended to mobilize resources. But many fear this could lead to a misallocation of resources reminiscent of the recent housing bubble. QE2 also might be ineffective in lowering nominal interest rates if lower real interest rates are offset by higher inflation expectations.

Only time will tell if Fed Chairman Ben Bernanke made the right call (or if Will Rogers was joking).

STEVE RICK is senior economist for the Credit Union National Association. Contact him at 608-231-4285.