In 2011 the US Federal Reserve seems likely to continue its stimulatory action with near-zero interest rates and the printing money commonly known as quantitative easing (QE). The Fed has been trying to generate inflation which would pull the US$ down and make US exports more competitive. However growth rates of 2% is not high enough to bring down the 9.6% unemployment rates.
Currently the Fed regards deflation a bigger risk that inflation and has indicated that it will avoid deflation at all costs – remember that deflation makes debts larger. However, Thomas Hoenig – a member of the Federal Open Market Committee – has constantly disagreed with QE. His rationale is that it will mean higher inflation in the future. He may well be correct as the impact of loose monetary policy and QE1 and QE2 may manifest itself in higher inflation down the track. One could say that there is a high level of uncertainty as we have never seen such a stimulus package of this level before. At present though much of the money created by the Fed still sits on the balance sheets of banks as lending growth has been anaemic. But Hoenig’s opposition to QE does have merit. QE will not lead to runaway inflation as long as the Fed is proactive to withdraw the stimulus once inflation starts to creep up. If the Fed waits too long then there is the real risk of double digit rate. The Fed needs to sell its bonds that it bought and thus take money out of the circular flow.
Historical examples – Zimbabwe, Argentina and Germany
These three countries went through a period of printing money at the expense of inflation rates well over 1000%. Zimbabwe – 2000’s, Argentina 1970’s, and Germany 1920’s. Although this seems like what the Fed is currently doing there is one very significant distinction. The Fed is printing money as part of its monetary policy. In the case of the three countries above those governments printed money as part of their fiscal policy and used the cash to pay government bills – it should be remembered that monetising the deficit leads to hyper-inflation. But isn’t this what the Fed is doing funding the government deficit by buying bonds? However the Fed is buying bonds in the secondary market and the proceeds flow to the private sector, not the government.
This stimulus should eventually start to lead to improved fundamentals in the US economy. But the Fed cannot drive economic growth by itself. Monetary policy is just one instrument of economic management. The government must also ensure that fiscal policy is conducive to generating effective deployment of resources and growth in productivity.