NEW YORK – “Legitimate reasons” exist to be cautious regarding quantitative easing, and before undertaking the task, the Fed should consider the costs and benefits, Federal Reserve Bank of Kansas City President Thomas M. Hoenig said Tuesday.
“Based on recent research and the earlier program of purchasing long-term securities — known as LSAP — I think the benefits are likely to be smaller than the costs, Hoenig told the National Association of Business Economists annual meeting, according to prepared text released by the Fed.
Since the financial markets “are far calmer than in the fall of 2008,” Hoenig said, “the effect of asset purchases could be even smaller than the 10 to 25 basis point estimate.” But, he added, even if interest rates fell slightly from QE, “the effect on economic activity is likely to be small. Interest rates have systematically been brought down to unprecedented low levels and kept there for an extended period. The economy’s response has been positive but modest.”
Since liquidity is high, QE money would likely go “into excess reserves, or government securities, or ‘safe’ asset purchases. The effect on equity prices is likely to be minor as well. There simply is no strong evidence the additional liquidity would be particularly effective in spurring new investment, accelerating consumption, or cushioning or accelerating the deleveraging that is hopefully winding down,” he said.
On the negative side, Hoenig said, that without clear terms and goals, it becomes an open-ended program, which keeps the funds rate too low and the Fed’s balance sheet too big. “The result is a further misallocation of resources, more imbalances and more volatility.”
Also, QE would set a “very dangerous precedent” that risks “undermining Federal Reserve independence” if there can be influence as to what the Fed purchases.
Hoenig added, that QE could lead to inflation as high as 5%, instead of the 2% or 3% that would allow demand to rise “in a systematic fashion.”
“While QE2 might work in clean theoretical models, I am less confident it will work in the real world,” Hoenig added. “Again, I will note that the FOMC has never shown itself very good at fine-tuning exercises or in setting and managing inflation and inflation expectations to achieve the desired results.”
Hoenig said beginning to normalize monetary policy would be best for the economy. He urged the Fed to slowly but systematically discontinue reinvesting principal payments from agency debt and mortgage-backed securities into Treasury securities, and to move interest rates, not high, but away from zero.
“In 2003 the FOMC delayed our efforts to raise rates,” he said. “In that period we reduced the federal funds rate to 1% and committed to keeping it there for a considerable period. This policy fostered conditions that let to rapid credit growth, financial imbalances and the eventual financial collapse from which we are still recovering. Had we been more forceful in our action to renormalize policy then, it’s likely we might have suffered far less in 2008 through 2010.”
To that end, he suggests removing the “for an extended period” language from the FOMC statement. “As the public adjusts to this, we should then turn to determining the pace at which we return the funds rate to 1%. Once there, we should pause, assess and determine what additional adjustment might be warranted. A 1% federal funds rate is extremely accommodative, but from that point we could better judge the workings of the interbank and lending markets and determine the order of policy actions that would support sustained long-term growth.”
He added, “Zero rates distort market functioning, including the interbank money and credit markets; zero rates lead to a search for yield and, ultimately, the mispricing of risk; zero rates subsidize borrowers at the expense of savers.”
Business contacts, Hoenig said, have told him “that interest rates are not the pressing issue. Rather, they are concerned with uncertainties around our tax structure; they are desperate to see this matter settled. They need time to work through the recent healthcare changes; and they are quite uncertain about how our unsustainable fiscal policy will be addressed. They are insistent that as these matters are addressed, they will once again invest and hire. QE2 cannot offset the fundamental factors that continue to impede our progress.”
