[David Malpass, Founder & President of Encima Global and former Deputy Assistant Secretary of the Treasury testified before the House Financial Services Committee on March 5, 2013 on the effectiveness of Federal Reserve monetary policy. A summary of his statement follows.]
The Federal Reserve has undertaken an extreme monetary policy. The Fed funds rate has been near zero for over four years, unique in our history. By borrowing heavily from banks, the Fed has expanded its balance sheet by more than $2 trillion (from $900 billion to $3.1 trillion). It has substantially lengthened the duration of its assets by selling all of its Treasury bills, which were once a mainstay of monetary policy, to buy longer-term Treasuries. This leaves the Fed with substantial interest rate risk and marks the end of an era for the Fed’s once ultra-liquid balance sheet.
In my view, the policies have been weakening and distorting the economy rather than providing stimulus. They are hurting savers, distorting markets, and redistributing capital rather than increasing it. The policies subsidize government, big corporations, big banks, foreign investment and gold, none of which is a robust private sector job creator, at the expense of small and new businesses and other job-creating parts of the economy. The result is a departure from market-based capital allocation that is contractionary in the same way that price controls, income redistribution and industrial policy are contractionary.
As the policies were expanded, real growth has slowed from 2.4% in 2010 to 2.0% in 2011 and 1.6% in 2012. Nominal growth, where a stimulative Fed policy should have its most influence, has also slowed from 4.3% in 2010 to 4.0% in 2011 to 3.5% in 2012. In effect, the U.S. economy has been going backwards. It is showing unprecedented weakness during an expansion, evidence of poor monetary, fiscal and regulatory policies.
The transmission mechanism of QE to the economy isn’t working under current circumstances of heavily regulated growth in private sector credit, so economic growth has been coming in below the Fed’s expectations. The money multiplier that connects the Fed’s creation of bank reserves to private sector credit growth has simply stopped functioning under current monetary and regulatory policies. The Fed’s balance sheet has been expanding without a corresponding expansion in private sector credit. Private sector credit growth was up only 1.6% ($384 billion) in the 2010-2012 period (through Q3), one of the factors holding the nominal GDP growth rate down. By comparison, government debt rose 32.4% ($3.5 trillion, nearly ten times as much) and the Federal Reserve’s liabilities rose 30.6% ($669 billion.)
The Fed is also pushing down yields for longer-term credit, benefitting a select group of favored borrowers at the expense of non-favored borrowers such as new businesses, small businesses and businesses considered risky by government regulators. Per Fed policy, the weaker the labor market, the more government bonds the Fed will purchase, with no limit. This threatens the private sector with an even more distorted capital allocation process, creating a feedback loop that discourages productive investment.
These distortions have been hurting economic growth throughout the recovery, as discussed in my December 4, 2009 Wall Street Journal article titled Near-Zero Rates Are Hurting the Economy: Capital is being rationed not on price but on availability and connections. The government gets the most, foreigners second, Wall Street and big companies third, with not much left over. For small businesses and new workers, capital rationing is devastating, spelling business failures and painful layoffs. Thousands of start-ups won’t launch due to credit shortages, in part because the government and corporations took more credit than they needed because it was so cheap.
By under-pricing credit for certain borrowers while applying regulatory limits on traditional lenders, credit ends up being rationed. The Fed stands ready to lend money to the government and the government-backed mortgage market at any price. Since regulators are enforcing capitalization and leverage requirements, the result of Fed bond purchases is a crowding out of lending to small and new businesses. As low rates are pushed out along the yield curve, capital is increasingly misallocated toward government and big corporations. This shows up in declining growth rates and less economic dynamism.
In addition to the contractionary economic impact, current monetary policy raises several other negatives:
- The Fed is buying some of the most high-priced assets in the economy — Treasury bonds and MBS — long after the 2008 financial crisis. Some of the steps the Fed took in the heart of the 2008 crisis were beneficial, for example the reduction in the Fed funds rate from 2% to 1% in October 2008 and the Fed’s purchase of high-yielding agency MBS to unfreeze the market in November 2008. However, the huge expansion of non-traditional measures in 2009-2012 extended well after the end of the crisis, harming market-based capital allocation.
- The Fed has greatly expanded its role in the economy, financial markets and capital allocation. The Fed has asserted the legal authority to make unlimited large-scale asset purchases on its sole discretion even when there’s no systemic crisis. That has huge implications for the future, when each slowdown will cause the markets to believe the Fed might buy assets.
- By using short-term financing (overnight bank loans) to buy long-term bonds, the Fed is creating a maturity mismatch for itself. The Fed’s massive buy-back of long-duration bonds has shortened the effective maturity of the national debt, overwhelming the Treasury’s important role in deciding the maturity. The result is a much more powerful Fed and a risk to taxpayers when interest rates are eventually allowed to return to market-based levels and the government refinances the debt at higher interest rates.
- The Fed now owes nearly $2 trillion at floating interest rates to a small group of commercial banks. This has taken the place of Treasury debt held by the private sector, which would have been broadly placed in the market (and would pay a slightly lower interest rate than the Fed’s 0.25% rate paid to banks.) When interest rates rise, the Fed and taxpayers will face a large increase in their interest payments to commercial banks, creating severe political challenges and market uncertainty.
- By connecting monetary policy to a specific 6.5% unemployment rate, the Fed has changed its mandate, in effect making itself accountable for a particular unemployment rate even though its policies don’t control the rate. The Fed should be focused on maximizing employment and keeping inflation low. The new target and the Fed’s giant bond portfolio interfere with the Fed’s decision process in achieving its statutory mandate.
- The Fed is actively managing consumer and market sentiment and encouraging risk-taking rather than relying on the quality of the monetary framework to encourage investment and hiring. In his September 13, 2012 press conference, Fed Chairman Bernanke said that the Fed assuring the public that it will take action if the economy falters should increase confidence and boost the willingness to spend. This Fed assurance that it will take action to support the economy is often described as the Bernanke put, a reference to a financial derivative that provides protection against losses. It is named after the Greenspan put, which equity and housing markets relied on to justify high leverage ratios in the 2000’s on the view that then-Chairman Alan Greenspan would keep interest rates low enough that asset prices were sure to increase. Over-confidence in the low-rate environment of 2004-2007 gave rise to the view that banks and investors should dance until the music stops, a process the Fed may be repeating.