The Fed Declares Independence: Will Open-ended Easing Work?

Posted by Diane Swonk on September 13, 2012

Fed Opens Door on New Era
In an unprecedented move, the Federal Reserve voted to expand its balance sheet by $40 billion per month via mortgage-backed securities (MBS) purchases until the labor market improves “substantially.”
Chairman Ben Bernanke was especially vague in his description of what “substantial” actually implies, in the press conference that followed the statement; he underscored that the policy is being executed in the context of price stability.

This open-ended approach to easing, contingent on an improvement in the labor market, has never been done. The focus on MBS over Treasury purchases allows the Fed to better target support for the housing market, a critical job creator. The bang for the dollar in boosting a sector that is already improving is much greater than just lowering Treasury yields, which are close to record lows.

The Fed also extended its forward guidance on holding short-term interest rates near zero to mid-2015 from late 2014. This is designed to provide investors with some assurance that the Fed intends to hold easy monetary policy longer than in the past (e.g., investors will have ample time to reap the returns of riskier and more productive investments).

There are risks to the Fed’s current policy. An excessive expansion in the Fed’s balance sheet could trigger new imbalances and bubbles that would need to be burst and dealt with just as the economy is healing. This is to say nothing of how high interest rates would need to be raised, to combat inflation if the Fed’s balance sheet is still large.

Bernanke went out of his way to address critics at his press conference. He argued that asset purchases by the Fed are not comparable to an increase in government spending; the Fed has actually reduced the deficit by turning over the profits from those purchases to the Treasury; he acknowledged the plight of savers, but countered that those costs are small when weighed against the benefits we all receive when the economy is stronger; and, he reassured inflation hawks that inflation is a much easier foe to fight than weak growth and disinflation.

Congress is actively trying to curb the Fed’s independence. Many would like to eliminate the dual mandate and have the Fed focus only on inflation. But the bottom line is, the Fed has a dual mandate to promote full employment AND price stability. That is the law, so if Congress doesn’t want the Fed to stimulate to reduce the unemployment rate, then members must first change that law.

For more on the Fed’s recent actions and future options, see the September issue of Themes on the Economy, under the research tab.

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