If you are ailing, and you take a medicine that doesn't work, do
you up the dosage or try something else?
For Ben Bernanke and the Federal Reserve, the answer seems
clear: More is always the way to go.
An open-ended commitment
In the meeting of the Federal Open Market Committee that
concluded September 13, the Fed decided on another round of
quantitative easing -- QE3, for those of you keeping score.
In essence, the Fed is lengthening its commitment to low
interest rates. It is now saying that it sees a likelihood of
keeping the Fed funds rate at "exceptionally low levels" at least
through the middle of 2015. Also, in announcing that it will make
additional purchases of mortgage-backed securities, the Fed did not
use a timetable or total amount to describe the extent of this new
program -- it merely made an open-ended commitment to purchase
additional mortgage-backed securities at a pace of $40 billion per
Over the past year, the Fed has put a great deal of emphasis on
how it communicates its policies, and it is significant that the
Fed is now signalling that low interest rates are here to stay for
the foreseeable future. Having lowered interest rates about as far
as it can, the Fed is now hoping to get extra psychological mileage
out of the message that people can expect these low rates to
continue for a long time.
Three problems with the policy
The stock market got a quick fix out of the announcement, but it
is important not to confuse the market's interests with the broader
well-being of the economy. There is some overlap, of course, but
stock valuation formulas yield higher prices when interest rates
are low. Given how short-sighted most stock investors are, the
promise of more low interest rates is enough to spark a rally,
regardless of whether it ultimately helps the economy.
Meanwhile, there are at least three reasons to believe that more
of the low-interest rate approach won't help:
It is robbing savers of interest.
Take money out of the pockets of people with savings, and you
take money out of the economy.
If creates a disincentive to lend.
Low interest rates are supposed to create an incentive to borrow,
but it takes two to tango. Loan volume has been weak since the
low interest rate program began. Could the connection be that low
rates offer an inadequate reward for the risk of lending?
It is vulnerable to an inflation shock.
The Fed notes that it is able to extend its policy because
inflation has been tame. However, inflation is always just one
new crisis away -- and rising tensions in Libya and Egypt are the
The first two of these may have prevented the economy from
responding to the Fed's medicine in the first place. The last could
be what closes out that prescription once and for all.