The Fed's Schizophrenia

Last week the Federal Reserve decided to curtail its purchases of securities after October bringing to an end its long experiment with quantitative easing (QE), presumably because it is more bullish on the economy. But the Fed also said it will continue to hold interest rates at zero indefinitely suggesting it is still bearish on the economy. The Fed's economic forecast was in fact marked down to less than 3 percent for the next several years. Perhaps the best term to describe the Fed's attitude is schizophrenic.

I for one will shed no tears for QE, which has troubled me as it morphed into a never-ending monetary stimulus program. QE1 was born in December 2008 in response to the banking crisis. The Fed began buying longer-term securities and mortgage-backed securities (MBS) of Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs). The Fed said it would buy up to $100 billion of the GSEs' debt and up to $500 billion of their MBS from banks and the GSEs themselves. The goal was to pump more money into the economy, shore up the banking system and boost the nation out of recession.

But the recession lingered so in November 2010 the Fed launched QE2 saying it would buy $75 billion of longer-termed securities a month. The economy remained weak. Then in September 2012 the Fed began QE3 increasing purchases to $85 billion a month. By then the economy was growing again, albeit sporadically. This year the Fed has been reducing its buying of debt to about $35 billion per month. So far the overall tab is $2.3 trillion in long-term treasuries and $1.7 trillion in GSE securities -- a total of $4 trillion.

These Fed actions have enabled the banks to amass reserves of $2.6 trillion which means they could create up to $26 trillion in new money. Of course, a major goal of the Fed is to encourage the banks to lend more readily, thus stimulating economic growth and creating jobs. But this effort has not thus far proven very successful. Meanwhile, the Fed's actions have destabilized the economy by encouraging risky behavior, such as excessive speculation in the stock market, a flood of IPOs, more mergers than can be justified economically and a general distortion of our capital markets.

Even though the Fed is moving to reduce its purchase of bonds, it indicates it will keep interest rates at near zero indefinitely. Fed Chairman Janet Yellen is clearly more concerned about slow growth and modest labor market gains than about inflation or increased financial instability.
In sum, the Fed is determined to continue its efforts to promote economic growth and job creation come what may. That is a laudable goal but it is politically risky. Given that the Fed exists outside the normal political process, it may lead to a strong reaction if and when inflation rears its ugly head again or we encounter a new financial crisis as our government tries to cope with all of that new debt the Fed has acquired.

Jerry Jasinowski, an economist and author, served as President of the National Association of Manufacturers for 14 years and later The Manufacturing Institute. Jerry is available for speaking engagements. September 2014