Tapering QE, Not the Recovery

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David Brady's picture

At the end of 2013, during Ben Bernanke’s final meeting as chairman, the Federal Reserve announced that it would begin to taper its asset purchases from $85 billion a month to $75 billion, which begins the phasing out the quantitative easing (QE) program. From its beginning, many pundits and economists believed QE to be a risky program that would cause economic instability in the United States. Those worries never materialized, but these critics still believe that the Fed’s decision to taper is long overdue. In fact, the decision to taper may be coming too soon. The economy is still in need of monetary stimulus. Therefore, as the taper begins, the Fed must show that it is committed to keeping interest rates low until the economy is in full swing or else risk damaging the recovery from the Great Recession.

In late 2010, many right-leaning economists, investors, and scholars, such as Niall Ferguson, John B. Taylor, Michael Boskin, and Jim Chanos, wrote an open letter to Ben Bernanke warning him of the dangers of undergoing a second round of QE. The letter warned of risks of currency debasement and inflation and urged the Fed not to implement QE2.[i] Over three years later, however, these concerns have not come to fruition. Inflation remains virtually nonexistent, and the dollar has remained stable. Rather than admitting they were wrong and reevaluating their positions, these pundits have continued to criticize QE and now insist that the Fed’s policies have been useless, they have not provided a boost to the economy, and that QE should be phased out.[ii]

The markets disagree. On initial news of the taper in June of 2013, they reacted negatively with bond yields sharply increasing and stock prices dropping. As this reaction to the Fed’s tapering announcement makes clear, unconventional monetary policy has helped the recovery by keeping interest rates low. The fear is that tapering will mean rising interest rates, which could derail the ongoing recovery because the natural interest rate still remains negative. As Brad DeLong explains, “financial markets simply do not believe the central bankers when they say that a present desire to ‘taper’ is completely unconnected with any future desire to raise short-term interest rates.”[iii]

Nevertheless, there are things that the Fed can do to balance its decision to begin tapering with the need for continued stimulus. Recognizing that the economy has not fully recovered, the Fed has shown that it is committed to staying aggressive even as it begins the taper. It is trying to convince financial markets that tapering and raising rates are not the same thing. Bernanke did an effective job ensuring investors of this after the December 2013 meeting. As a result, stock markets are at record highs, bond yields have stabilized, and the economic data has continued to improve since Bernanke first hinted of tapering in June. Still, the U.S. economy has a long way to go, and higher interest rates are exactly what the U.S. economy does not need.

Moreover, in order to keep economic growth expanding and the end of QE from being the end of the recovery, the Fed must more aggressively use forward guidance, which is declarations about future interest rates, as Paul Krugman, Mike Woodford, and others have argued. The new Fed leader, Janet Yellen, and vice chair Stanley Fischer have a tough task ahead. As the Fed phases out QE, and Yellen’s term begins, she must strongly use forward guidance promising to keep rates low by “credibly promising to be irresponsible,” as Krugman first argued in 1998.[iv]

Furthermore, there are additional things that the Fed can do to make the QE exit easier. For example, economist Alan Blinder argues that the Fed should reduce the interest rate it pays to banks on excess reserves. This will force banks to hold less cash at the Fed, and some of that money would be used to increase lending and boost the economy. And since the excess reserves are Fed liabilities, basic accounting rules say that holding fewer reserves would likewise shrink the Fed’s assets, making the QE exit easier.[v] Bernanke has not wanted to lower the interest rate on excess reserves, but it could be a possibility for the new leadership to consider. The recovery efforts and the global economy still need strong Fed action.

In conclusion, no one should believe that QE was a worthless program and phasing it out has been long overdue. Unconventional monetary stimulus has been a major boost to a struggling economy as it faced major political headwinds. The dismal warnings about QE have never come true. As Bernanke’s term ends and Yellen’s begins, this is no time for the Fed to claim “mission accomplished.” The recovery from the Great Recession is far from complete. The economy is well underperforming its potential output and inflation remains low. Forward guidance should be the next tool that Yellen and the Fed use to try to get the U.S. economy back to full employment even as it phases out QE.

 

References: 

[i]Cliff Asness, M. Boskin, R. Bove, C. Calomiris, J.Chanos, J. Cogan, N. Ferguson, N. Gelinas, J. Grant, K. Hassett, R. Hertog, G. Hess, D. Holtz-Eakin, S. Klarman, W. Kristol, D. Malpass, R. McKinnon, D. Senor, A. Shlaes, P. Singer, J. Taylor, P. Wallison, G. Wood. “Open Letter to Ben Bernanke.” Wall Street Journal. November 15, 2010.
http://blogs.wsj.com/economics/2010/11/15/open-letter-to-ben-bernanke/

[ii] John B. Taylor. “Once Again, the Fed Shies Away From the Exit Door.” Wall Street Journal. July 11, 2013. http://online.wsj.com/news/articles/SB1000142412788732389970457858730379...

[iii] Brad DeLong. “The Taper and Its Shadow: Central Bankers Need to Explain the Risks of Further Quantitative Easing.” Project Syndicate. September 27, 2013.
http://www.project-syndicate.org/commentary/the-absence-of-compelling-re...

[iv]Paul Krugman. “Tobin and the Taper (Wonkish). The Conscience of a Liberal. New York Times. September 13, 2013. ”http://krugman.blogs.nytimes.com/2013/09/13/tobin-and-the-taper-wonkish/

[v]Alan Blinder. “Easing the Angst About Fed Easing.” Wall Street Journal.” March 12, 2013. http://online.wsj.com/news/articles/SB1000142412788732362880457834841067...