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Economic Insights

As Chairman Bernanke departs, it's time to assess the effectiveness—and potential risks—of the bold policy moves that defined his tenure at the central bank. 

As investors contemplate the leadership change at the Federal Reserve, they have begun increasingly to question the effectiveness of present policies and also raise concerns about longer-term risks. All are well aware that various versions of the Fed's easy monetary policy have persisted for years, and yet the recovery remains subpar. At the same time, all are aware that the buildup of Fed-provided liquidity has left large unused reserves in the system that could lead to excesses over the longer term, including general inflationary pressures. The observations and concerns are all legitimate, but it would be premature to label monetary policy a failure or to see an inflationary future as inevitable.

Of one thing all can be sure: the Fed has pursued a very easy monetary policy for some time now. It brought short-term interest rates down to near zero during the 2008–09 financial crisis, and has held them there since. Further, according to the statements by outgoing Fed chairman Ben Bernanke, policymakers plan to keep enough liquidity flowing to hold short-term interest rates at their current low levels until 2015, at the earliest.1 In addition to this hefty conventional stimulus, the Fed has also offered markets and the economy a series of special liquidity injections, termed quantitative easings.

The first such special effort began in November 2008 in the midst of the financial crisis. Then, the Fed set out to buy $600 billion in mortgage-backed bonds and bank debt on the open market. It renewed the program in November 2010, buying an additional $600 billion in Treasury securities over the following seven months, after which it paused in this particular aspect of its strategy. Soon thereafter, however, in September 2012, monetary policymakers, disappointed with the pace of the economic recovery, initiated a third round of quantitative easing. This one made an open-ended commitment to buy $40 billion a month in mortgage debt and $45 billion a month in Treasury securities. It remains in effect. These three programs have to date increased the Fed’s portfolio of bond holdings dramatically. Prior to the 2008–09 recession, the Fed held no more than $700–800 billion in bonds in its portfolio, almost all Treasury notes. As of early December, however, the Fed's securities holdings amounted to almost $3.7 trillion, $2.2 trillion in Treasuries and the rest mostly in mortgages.2

Yet despite all this and more than a four-fold expansion in the Fed's balance sheet, more than 35% a year for almost five years, policymakers have failed to elicit the economic response they have sought. The pace of expansion has consistently disappointed, with the economy growing in real terms at a paltry 2.2% a year since the recovery began in mid-2009, far short of the 4–5% rate typical of past cyclical recoveries or even the economy's larger-term average annual growth rate of 3.5%. Even the third quarter, updated recently to a 3.6% annualized real growth rate, only looked good next to recent past experience. It too still fell short of past recoveries. What is more, the bulk of the growth surge reflected a jump in inventory stocks. Real final sales grew a mere 1.9%. Similarly, labor markets have disappointed. The 7.0% unemployment rate reported for November was well down from the highs of 2010, but still is far from full employment. And it would be much higher if it counted the millions who have given up the search and dropped out of the workforce altogether. Accounting for them would put the unemployment rate closer to 9.0%.3 Other economic statistics confirm this disappointing picture. It is an economic response, to be sure, but hardly one consistent with the massive stimulus provided by the Fed.

The problem now facing the Fed seems to lie in an excess of caution among financial institutions. Because banks have remained reluctant to lend, the flood of Fed-provided liquidity has failed to reach the general economy. In 2010, the first full year of this recovery, when the Fed had already embarked on its second phase of quantitative easing, bank lending nationally actually fell by 5.8%. In 2011 and 2012, as the Fed moved toward its third phase of quantitative easing, bank lending grew at a paltry average rate of 2.3% a year, barely keeping up with inflation. Nor has bank lending accelerated this year, holding through November to that same slow 2.3% annualized rate of expansion. Against such a backdrop, it is hardly surprising that bank reserves have simply piled up in bank vaults and in their accounts with the Fed. Lending has progressed so slowly, in fact, that presently fully 95% of all reserves held by banks stand in excess of what they need to back their deposits and loans, a veritable ocean of unused liquidity.4

It is easy enough to explain this reluctance among financial institutions. They came close to bankruptcy in 2008–09, an event that tends to breed caution in managements. Legislative initiatives, such as the Dodd-Frank bill,5 by insisting on safeguards to prevent a recurrence of 2008–09, have reinforced the bias toward timidity, not the least because financial institutions could now face severe penalties in the event of a mistake. Understandable as the case may be, it has still kept a good deal of the monetary stimulus from reaching Main Street. Put in more technical terms, the caution explains why the velocity with which money and reserves circulate through the economy has slowed. While this response, or rather lack of response, has frustrated the Fed’s objectives, it also has confronted policymakers with a second, more fundamental problem. The enormous backlog of liquidity left in financial institutions, should it begin to move, could suddenly change what is a sluggish, lackluster economic environment into a hyped one full of excess, including potentially a generalized acceleration in inflation.

Fortunately for investors, the Fed is well aware of this problem. It knows that it must remove this excess in time to avoid the potential economic hype and inflation. That, however, is far from a straightforward chore, for the Fed also knows how much harm it could do to an already weak recovery were it to shut down the flow of liquidity too radically or too suddenly. Chairman Bernanke, more than once, has laid out a careful plan to balance these two concerns: to continue the support of monetary ease, such as it is, but also to gradually reduce the liquidity overhang. According to his comments, it could take until 2015, maybe not even until 2019, to complete the transition. His proposal last June to begin a slight tapering in the extent of quantitative easing was meant as a preliminary step in that process, though it was never executed. Presumptive incoming chairperson, Janet Yellen, will almost surely continue with Bernanke’s plan. She, after all, worked with him to devise it in her role as vice chairperson. No one, including the policymakers at the Fed, pretends that this ongoing balancing act will be easy, but the Fed's leadership is clearly determined to execute it.

Investors have good reason to look warily at such policy gymnastics. This is, after all, an unprecedented effort. But it would nonetheless be unwise, surely premature, to twist portfolios in anticipation of a Fed policy error, on either side of the balance. It certainly is not likely that the Fed will act so precipitously as to stall the recovery. That would fly in the face of everything it has done to date. On the other side, the Fed has the luxury of time. The economic slack, both in this economy and globally, suggests that it would take a long time and a lot of error on the Fed’s part before anyone had a need to cope with excessive hype and certainly a generalized acceleration in inflation. The Fed can use this long hiatus to reduce the excess gradually. Investors, consequently, have ample time to position their portfolios for any failure on this front, and, if the Fed can really execute policy as deftly as it plans, they may never need to do so.  


*I would like to thank Lord Abbett Regional Manager Jim Armstrong for suggesting this line of inquiry.
1 Data from the Federal Reserve.
2 Ibid.
3 Data from the Department of Commerce.
4 Data from the Federal Reserve.
5 That is, (former) Senator Christopher Dodd (D-CT) and Representative Barney Frank (D-MA).

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ABOUT THE AUTHOR


Critical Releases in the Week Ahead

Milton Ezrati examines the key economic and financial releases scheduled for the coming week.

Key Mover:

Personal Income for November*
Mon., December 23, at 8:30 a.m. ET
Previous: -0.1% • Prospect: +0.3%

Personal Outlays for November*
Mon., December 23, at 8:30 a.m. ET
Previous: +0.3% • Prospect: +0.4%

The income drop reported for October in part reflected the government shutdown, but more a transitory drop in proprietors' income, always volatile. Neither should influence the report for November. Because November retail sales already reported strong, spending, as tracked in this report, should outpace income by a modest margin.
*Source: Department of Commerce.

Others to Watch:

Consumer Sentiment for December*
Mon., December 23, at 9:55 a.m. ET
Previous: 82.5% • Prospect: 82.7%

The figure should rise modestly from the preliminary report of earlier this month, mostly on relief that Washington seems to have settled on a budget deal.
*Source: University of Michigan.

Durable Goods Orders for November*
Tue., December 24, at 8:30 p.m. ET
Previous: -2.0% • Prospect: +1.5%

Always a volatile indicator, orders were reported down in October after unsustainable strength reported in September. The resulting balance should allow a modest rise in November consistent with the fundamentals.
*Source: Department of Commerce.

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