-- John Kemp is a Reuters columnist. The opinions expressed are his own --
By John Kemp
LONDON, Jan 14 (Reuters) - Fed Chairman Ben Bernanke’s speech yesterday was the most detailed explanation to date of the “alternative” monetary policies the central bank has been implementing since last autumn. In it he set out a defence of the technique, sought to rebut criticism it would lead to higher inflation in future, and set out an exit strategy for returning to more conventional methods of monetary control when conditions improve.
Bernanke was particularly anxious to reject comparisons between the current strategy and the quantitative easing pursued by the Bank of Japan in the late 1990s, and which he himself foreshadowed in a now famous speech given in 2004. Bernanke prefers to characterise the Fed’s current strategy as credit easing (CE) rather than quantitative easing (QE).
The Bank of Japan’s quantitative strategy was a response to the relatively straightforward problem of deflation in both asset prices and the price of goods and services. QE was explicitly designed to generate a higher (positive) rate of inflation. Since interest rates had already been cut close to zero, the bank tried to increase inflation by raising the quantity of money in circulation.
It began to define the operational target for monetary policy in terms of the quantity of reserves commercial banks held at the central bank, rather short-term interest rates. Ultimately the Bank of Japan hoped excess monetary growth would trickle through to increases in real activity and more importantly a higher rate of inflation.
Crucially, the Bank of Japan set its target in terms of the quantity of reserves, which show up on the liability side of the central bank’s balance sheet. To create them, the Bank of Japan bought a wide range of assets from the banking system via open market operations, which expanded the asset side of its balance sheet as well.
But Bernanke’s point is that the asset purchases were incidental to the strategy. The Bank of Japan was focused on the volume of reserves (the liability side) and fairly indifferent to the type of instruments it was purchasing (adding to the asset side).
It focused on the quantity of reserves rather than the type of assets it was buying because it was trying to counter a general problem of deflation by raising the total volume of money in the economy. Banks themselves could be left to decide where to extend additional loans. Extra credit would be allocated throughout the economy via normal market mechanisms, with interest arbitrage ensuring credit ended up where it could be used most efficiently and brought the highest return.
In contrast, Bernanke argues the Fed’s strategy is more nuanced. It focuses on buying specific types of securities in the open market (adding them to the asset side of the balance sheet). The fact many are bought directly from the commercial banks, resulting in an increase in the volume of excess reserves they hold with the central bank (expanding the liability side of its balance sheet) is incidental. Increasing bank reserves is a side effect of the Fed’s policy, not the central aim.
The Bank of Japan responded to a deflation problem by expanding the size of its balance sheet; the Fed is responding to a credit crisis by changing the balance sheet’s composition.
Unlike the Bank of Japan, the Fed is more concerned about the disappearance of credit to certain types of borrowers. By buying certain classes of assets in highly targeted operations, the Fed hopes to restore liquidity and get markets operating again.
Bernanke conceded that the crisis facing the Fed is in many ways worse than that which faced the Bank of Japan. Because some credit markets have essentially disappeared, the Fed cannot rely on normal market mechanisms and interest arbitrage to ensure that extra funds end up where they are most needed. It has to direct liquidity to specific sectors of the economy, rather like a central planner, rather than just adding general reserves and waiting for the banks to direct credit to the most-needy borrowers.
It is this highly targeted and discriminatory approach that caused Stanford economist John Taylor to complain the Fed was running a monetary-industrial (“monindustrial”) policy. In a stinging critique that seems to have wounded senior Fed officials, Taylor argued the Fed was usurping the function of the market. It should instead use a more neutral mechanism and leave the market to allocate the extra funds.
Bernanke clearly believes a neutral policy will not work because some markets have broken down for the time being. Because the Fed’s strategy is focused on adding liquidity to very specific parts of the market, Bernanke prefers to characterise it as credit easing rather than quantitative easing.
While there are important but subtle differences between QE and CE, the eventual impact on inflation could be the same, which is why the Fed is so keen to downplay comparisons with the Bank of Japan’s earlier programme or Bernanke’s “helicopter” speech.
The Fed is caught in a dilemma. Public and business confidence in the eventual effectiveness of monetary and fiscal responses is crucial to restarting lending markets and economic growth. So the Fed is not anxious for its own CE strategy to be compared with the relatively ineffective QE strategy pursued by the Bank of Japan in the late 1990s and early 2000s.
But the market’s real fear, one that the Fed is anxious to downplay, is the policy will eventually work only too well. Conventional monetary theory (MV=PT) says that for a given level of demand for liquidity (velocity, V), increases in the money supply (M) are expressed as an increase in real output (transactions, T), the price level (P), or some combination of both.
Deliberately or not, the Fed’s CE strategy is increasing the level of commercial bank reserves, which are the most potent component of the monetary base (M). Many commentators have expressed concern this massive monetary expansion must eventually spark an upsurge in inflation once the economy begins to recover.
Bernanke counters that the current increase in the monetary base (M) is being offset by a corresponding rise in the demand to hold liquid instruments (a decline in V) so there is no current impact on inflation.
Once the crisis passes, demand for liquidity should fall (V will rise). At this point, the extra bank reserves could indeed become inflationary. But Bernanke argues it would be a relatively simple matter to begin withdrawing them.
Much of the liquidity has been created by buying assets with a short maturity (such as commercial paper) which could simply be allowed to run off. Liquidity added by buying longer-dated assets could be absorbed by selling more government debt to the market (overfunding).
This is much too optimistic. Confidence (V) is notoriously volatile and hard to forecast. Once the economy starts to stabilise and confidence returns, demand for liquidity could fall swiftly and the same quantity of excess reserves could quickly become inflationary. At that point volumes rather than intentions will matter more; targeted CE measures would effectively become generally inflationary QE ones.
The Fed would have to match the return of confidence with an equally nimble withdrawal of excess reserves. But past experience suggests the Fed finds it hard to withdraw liquidity promptly once a crisis has passed. There is no reason to think the central bank would be any more successful this time.
Just the sheer multiplication of monetary policy instruments has made the decision-making process much harder. The Federal Open Market Committee experienced enough difficulty running an effective monetary policy in the late 1990s and early 2000s when all the FOMC members had to worry about was setting a single target interest rate, and arguably got it badly wrong.
The idea the Fed will be able to manage a plethora of CE/QE programmes to withdraw liquidity promptly and in a carefully calibrated manner to avoid an uptick in inflation requires a big leap of faith.