Leading up to Janet Yellen’s Jan. 6 confirmation vote, the Federal Reserve recently announced that it will taper back its bond-buying program, known as quantitative easing. This was encouraging news for inflation hawks, if barely so. Right now, the Fed buys $85 billion worth of mortgage-backed securities and Treasury bonds every month from financial firms. These firms, flush with cash from the Fed, then diffuse those dollars throughout the economy through loans and other financial activities. Going forward, the Fed will roll back its monthly purchases from $85 billion to $75 billion, or roughly 11 percent. This is a good start, but the Fed should go further and taper away the rest of quantitative easing.
The policy always was a puzzling reaction to the financial crisis. The Fed launched it to forestall a crisis like the Great Depression, which was mainly caused by a liquidity shortage. Policymakers are well aware of this, thanks in large part to the scholarship of the late Anna J. Schwartz, who co-authored “A Monetary History of the United States” with Milton Friedman. However, different crises have different causes, and the 2008 financial crisis was very different from the Great Depression. As Schwartz told The Wall Street Journal at the outset of the crisis, “The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.”
The federal government’s decades-long crusade to increase homeownership rates gave financial firms an incentive to take on far more risk than they would have in a free market. It took a long time for financial markets to realize this, but when they did, all hell broke loose. Banks suddenly became wary. They were reluctant to lend, regardless of their cash situation.
To make matters worse, when the crisis broke, politicians gave in to their natural impulse to fight the previous battle rather than the current one. Hence, policies such as the Troubled Asset Relief Program, fiscal stimulus, Cash for Clunkers and the various bailouts and rounds of quantitative easing. None of this helped to calm the nation’s turbulent economic waters, because through all of this, a key ingredient was missing — predictability.
As Stanford economist John B. Taylor puts it in his book “Getting off Track”: “[B]anks became reluctant to lend to other banks because of the perception that the risk of default on the loans and/or the market price of taking of such risk had risen.” Again, the problem is not a lack of cash. It is fear. There are many ways to calm that fear, and quantitative easing is not one of them. The most effective way is regime certainty. When the government bails out some firms but not others, with no discernible pattern aside from the Treasury secretary’s whim, of course markets will clam up.
Ideally, there would be no bailouts or other such infusions of cash at all. However, if there must be, they should be carried out along bright-line rules for which firms and investors can plan. The current approach of “Ready! Fire! Aim!” must end. It is not enough for the players to know the rules of the game. They must also know those rules will actually be followed.
Tapered quantitative easing may also be sending a political signal. Fed watchers might see the tapering as a sign of things to come when Ms. Yellen, Ben S. Bernanke’s likely successor as Fed chairman, takes charge. Johns Hopkins University economist Steve Hanke argues that Ms. Yellen is more hawkish on inflation than her dovish reputation suggests. The tapering announcement seems to confirm Mr. Hanke’s thesis. As the Fed’s current vice chairman, she already has significant say on Fed policy. She has publicly supported the new Basel III reserve banking standards, which would require banks to hold more of their capital in reserve. That would decrease the amount of money in circulation — the exact opposite effect of quantitative easing — and help keep inflation in check.
Kremlinology aside, the fact is that quantitative easing has nothing to do with the root causes of the financial crisis. The Fed has prescribed not only the wrong medicine, but medicine that comes with a harmful side effect — inflation.
The coming 11 percent reduction in quantitative easing is a good start. The Fed should taper the rest of QE in the near future. That would truly help keep inflation in check, bolstering the stable and honest price system that is fundamental to the economy’s health.