The Fed Makes Dramatic Decisions
Last Wednesday, Federal Reserve Chairman Ben Bernanke made two very important announcements that got lost in the year-end fiscal cliff shuffle.
One; as expected, Bernanke announced extension of $85 billion/month in asset purchases. Not a surprise.
The surprise was how long they would be extended.
The biggest announcement was that the extension of said purchases would last at least until the unemployment rate dropped to 6.5%. He estimated that would be in mid-2015.
The Fed is taking a huge risk adding to its debt load. This could have unintended long-term consequences affecting the economic stability of the United States.
The Dual Mandate
Always keep this clearly in mind…
The Fed’s overriding Congressional directive is the “dual mandate” – price stability and maximum employment. Bernanke talks about it literally every time he speaks.
The Fed knows all about price stability. It has used changes in the federal reserve’s prime interest rate for decades to prevent wild fluctuations of inflation or deflation.
The Fed knows practically nothing about how to promote maximum employment. For that, it has no well-defined tools. They only announced a framework understanding of it in January of this year!
Never forget that.
On Wednesday, the prime focus was squarely on maximum employment.
In that realm The Fed is in uncharted waters in very rough seas where it has never been before. Bernanke made that abundantly clear during the question and answer session following his reading of the latest FOMC statement.
Unexpected consequences are why there is ample reason for concern.
Dollars and Sense
On Wednesday, Bernanke almost casually announced adding $2.5 trillion in new debt to The Fed’s balance sheet. That is more than double what it has now. The Fed had practically nothing on its balance sheet before the Great Recession.
If continued, as now projected, The Fed could be pushing $5 trillion on it’s balance sheet by the end of 2015. That is a lot of debt to take on!
Operation Twist and Quantitative Easing
The Fed’s new debt will come from two programs that were scheduled to be terminated the end of this month. They just got extended for years.
At $85 billion/month, that is $1.02 trillion in new security purchases per year. The two programs serve two purposes.
One program, Operation Twist, is $45 billion/month of long-term treasury security purchases to hold down inflation. It extends a program originally started in September 2011. It supports the price stability mandate.
It will probably include short-term treasury purchases, too. After all, selling all your short-term securities to buy long-term ones is bound to run out.
Also, as it so happens, it is the primary lender for financing federal deficits through treasury purchases.
The other program is another round of QE or Quantitative Easing. This latest $40 billion/month QE started in September. Some are calling the new extension QE4.
This program is public-sector mortgage-backed security purchases. It supports the maximum employment mandate. It stimulates economic activity by providing more money for bank to loan for new home purchases, housing construction, etc.
At the current rate of decline, unemployment will take another 19 months to drop to 6.5%.
Bernanke made a point of saying that would only be one consideration over ending current “accommodative monetary policies”.
Over months, The Fed has been inching its way slowly into the murky waters of “maximum employment” without a seaman’s chart. Short term, temporary emergency measures are transitioning into the long-term.
This includes Operation Twist, quantitative easing and the other steps taken early in the financial crisis that have built a substantial exposure for The Fed itself over the longer term. It will be at least 6 years minimum into the process before backing out.
The attempts are what Bernanke euphemistically calls unconventional monetary tools. These are unproven weapons in the long fight against unemployment caused by the Great Recession.
The Fed’s primary weapon in monetary policy, adjusting the federal interest rate, ran out of bullets four years ago.
During the question and answer session Bernanke openly worried over the “unexpected consequences” that might come about because of these untested and unproven unconventional monetary policies.
If Ben Bernanke is worried about “unexpected consequences” then perhaps we should be to.