Ever since the U.S. Federal Reserve lowered its benchmark rate almost to zero and embarked on a series of large-scale asset purchases, Chairman Ben Bernanke has been using his pulpit to explain how it all is supposed to work.
In a nutshell: The Fed buys risk-free Treasury securities, depressing the yields. The public is goaded into buying riskier assets, such as stocks and corporate bonds, sending those prices higher. Businesses financing themselves with equity have more money to invest. Consumers feel wealthier and spend more.
Whenever I hear the bit about risk-taking, I wonder what the dividing line is between encouraging higher asset prices and creating froth in asset markets. How does the Fed know when asset prices have gotten out of whack?
Good question. The Fed can’t control how its money creation gets allocated. It hopes the money flows from asset prices into the real economy, but that isn’t always the case. For example, an individual’s decision of what to buy -- goods and services versus stocks and bonds -- depends on the expected return, said David Beckworth, an assistant professor of economics at Western Kentucky University in Bowling Green. “I might put off buying a new car if I could get a great return on buying a new home,” he said.
That’s exactly what happened in the last decade, when home prices became untethered from their anchors.
“The value of housing went up more than the real value determined by the flow of services people get from it,” said Michael Bordo, a professor of economics at Rutgers University in New Brunswick, New Jersey.
What’s more, all that housing wealth translated into unspectacular economic growth. The growth rate of real gross domestic product from 2001 to 2007 was below the postwar average. That was true of all of the individual metrics -- employment, consumer spending, investment, wages and salaries -- with the exception of corporate profits.
Then there was the experience of the 1970s, where monetary stimulus went into commodity prices and from there to goods and services prices, giving us “the great inflation,” Bordo said. Or it can happen in the stock market, with equity prices rising faster than can be justified by fundamentals.
In a speech last week, Fed Governor Jeremy Stein described what he said was “a fairly significant pattern of reaching-for-yield behavior” in both the high-yield and syndicated-loan markets. If that was the goal of Fed policy, then by all rights it has been successful.
Stein went on to say that even if his assessment were correct and junk-bond investors ended up taking a hit, “it need not follow that this risk-taking has ominous systemic implications.”
Uh-huh. And we all remember just how well the subprime crisis was contained.
I wouldn’t presume to know whether the narrow spread between junk-bond and Treasury yields or the rise in U.S. farmland prices is suggestive of an asset bubble. Nor am I passing judgment on the Fed’s monetary accommodation. What I am saying is that if the stated goal of the central bank is to prod the public to take risks, and the public complies with the Fed’s wishes, where does that leave us?
“The Fed has done a poor job of explaining the transmission of monetary policy” once the funds rate hits zero, said Marvin Goodfriend, a professor of economics at Carnegie Mellon University and a former research director at the Federal Reserve Bank of Richmond. “They haven’t described it as a monetary phenomenon.”
And no wonder. Monetarists are a dying breed at the Fed, which is curious since inflation is always and everywhere a monetary phenomenon (thank you, Milton Friedman).
Goodfriend said the Fed may have decided to avoid talking about money at a time when the Fed’s balance sheet has ballooned to $3 trillion from a pre-crisis level of about $850 billion. The public may not understand how the Fed creates reserves out of thin air or what the money multiplier is, but the mere mention of “printing money” seems to capture the imagination.
Back in the old days, the Fed didn’t talk much about monetary policy: how it worked or what the target interest rate was. Nowadays Fed officials don’t stop talking. In fact, talk, or “communication strategy” as it is known, has been elevated to a policy tool used to guide expectations and explain intended results.
It might be better if the Fed went back to the old way of describing how policy works.
“The Fed provides more money than people need, and they try to spend it away on things,” Goodfriend said.
Nor is it useful to talk about policy in terms of forcing people to take risks, he said. As a practical matter, who knows what the right level of risk is?
The Fed continues to usher us down the risk path, with neon lights to guide the way. Yes, policy makers talk about reducing unemployment -- one of the Fed’s dual mandates -- but the public must have trouble understanding the linkage between taking risks (bad, based on recent experience) and creating jobs (good). If the Fed can’t do a better job of explaining policy, maybe it should consider talking less.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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