The Federal Reserve's Policy Dead End
By MARTIN FELDSTEIN
Quantitative easing hasn't led to faster growth. A better recovery depends
on the White House and Congress.
The Federal Reserve recently announced that it will increase or decrease
the size of its monthly bond-buying program in response to changing
economic conditions. This amounts to a policy of fine-tuning its
quantitative-easing program, a puzzling strategy since the evidence
suggests that the program has done little to raise economic growth while
saddling the Fed with an enormous balance sheet.
Quantitative easing, or what the Fed prefers to call long-term asset
purchases, is supposed to stimulate the economy by increasing share prices,
leading to higher household wealth and therefore to increased consumer
spending. Fed Chairman Ben Bernanke has described this as the
"portfolio-balance" effect of the Fed's purchase of long-term government
securities instead of the traditional open-market operations that were
restricted to buying and selling short-term government obligations.
Here's how it is supposed to work. When the Fed buys long-term government
bonds and mortgage-backed securities, private investors are no longer able
to buy those long-term assets. Investors who want long-term securities
therefore have to buy equities. That drives up the price of equities,
leading to more consumer spending.
But despite the Fed's current purchases of $85 billion a month and an
accumulation of more than $2 trillion of long-term assets, the economy is
limping along with per capita gross domestic product rising at less than 1%
a year. Although it is impossible to know what would happen without the
central bank's asset purchases, the data imply that very little increase in
GDP can be attributed to the so-called portfolio-balance effect of the
Fed's actions.
Even if all of the rise in the value of household equities since
quantitative easing began could be attributed to the Fed policy, the
implied increase in consumer spending would be quite small. According to
the Federal Reserve's Flow of Funds data, the total value of household
stocks and mutual funds rose by $3.6 trillion between the end of 2009 and
the end of 2012. Since past experience implies that each dollar of
increased wealth raises consumer spending by about four cents, the $3.6
trillion rise in the value of equities would raise the level of consumer
spending by about $144 billion over three years, equivalent to an annual
increase of $48 billion or 0.3% of nominal GDP.
This 0.3% overstates the potential contribution of quantitative easing to
the annual growth of GDP, since some of the increase in the value of
household equities resulted from new saving and the resulting portfolio
investment rather than from the rise in share prices. More important, the
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rise in equity prices also reflected a general increase in earnings per
share and an increase in investor confidence after 2009 that the economy
would not slide back into recession.
Earnings per share of the Standard & Poor's 500 stocks rose 50% in 2010 and
a further 9% in 2011, driving the increase in share prices. The S&P
price-earnings ratio actually fell to 17 at the start of 2013 from 21 at
the start of 2010, showing the importance of increased earnings rather than
an increased demand for equities.
In short, it isn't at all clear that the Fed's long-term asset purchases
have raised equity values as the portfolio balance theory predicted. Even
if it did account for the entire rise in equity values, the increase in
household equity wealth would have only a relatively small effect on
consumer spending and GDP growth.
There is one further puzzle about the quantitative-easing program. The
Fed's purchase of Treasury bonds and other long-term securities has not
been nearly as large as the increase in the government debt during the same
period. The Fed's balance sheet has grown by less than $2.5 trillion since
the summer of 2007, while the federal debt has grown by more than twice
that amount just since the beginning of 2009. As a result, the public has
had to absorb more than $2 trillion of net government debt during the past
three years. At best, the Fed's long-term asset purchases reduced the
extent to which the federal deficits crowded out equity purchases.
The Federal Reserve has rationalized its use of long-term asset purchases
and its explicit guidance about future values of short-term interest rates
by noting that conventional monetary policy-lowering the federal-funds rate
- is not possible now that the fed-funds rate is very close to zero. With a
dual mandate that includes growth as well as price stability, the Federal
Open Market Committee apparently feels a compulsion to do something.
Unfortunately, the evidence suggests that it hasn't worked.
Mr. Bernanke has emphasized that the use of unconventional monetary policy
requires a cost- benefit analysis that compares the gains that quantitative
easing can achieve with the risks of asset-price bubbles, future inflation,
and the other potential effects of a rapidly growing Fed balance sheet. I
think the risks are now clear and the benefits are doubtful. The time has
come for the Fed to recognize that it cannot stimulate growth and that a
stronger recovery must depend on fiscal actions and tax reform by the White
House and Congress.
Mr. Feldstein, chairman of the Council of Economic Advisers under President
Reagan, is a professor at Harvard and a member of The Wall Street Journal's
board of contributors.
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Received on Fri May 10 2013 - 11:03:53 EDT
