Why the Fed’s Efforts Are Putting the U.S. Economy at Risk

To the relief of borrowers around the world, the U.S. Federal Reserve Board is holding off on tapering its bond-buying program.

Global equity markets rallied last week on word of the decision. It’s no secret that investors are among the biggest winners from the billions the Fed pours into the treasury market every month. Less clear, however, is what Quantitative Easing is doing for the economy. After four years of a so-called recovery, the U.S. economy is struggling to scratch out 2 percent growth, while the national jobless rate remains north of 7 percent.

[Hear More: Bud Conrad: The Fed Was Spooked by a Rise in Interest Rates]

Yes, cheap money polices did help stabilize a reeling housing sector, that shouldn’t be dismissed, but what else does the Fed have to show for near-zero short term interest rates and the fortune spent lowering longer term rates through its bond buying program?

More than 11 million Americans are still looking for work. Even the modest strides the economy has taken in lowering the jobless rate aren’t coming from more people finding jobs and earning pay cheques. Instead, the downtick in the headline employment number is due to job seekers becoming so discouraged that they stop looking for work and drop out of the labour force measurement all together.

In a quest to get economic activity churning again, the Fed and other growth-hungry central banks are running headlong into a bleak irony — the longer they stick with extraordinary measures, the less extraordinary those measures become. A dramatic reduction in short term rates packs a big punch when it first happens, but the jolt wears off as rates continue to stay low.

When the Fed initially chopped interest rates, corporations and households alike saw the record-low rate conditions as a once-in-a-lifetime opportunity. Any future plans to borrow were moved up in order to take advantage of a gift horse before it galloped away. The flip side of all that borrowing, of course, is an increase in spending. As months of low rates turned into quarters and quarters into years, a near zero interest rate environment became the norm, rather than the exception. Once that happens, low rates no longer create the same amount of borrowing and spending that they did in the early days. Of course, that’s not what the Fed’s models predict will happen and it’s certainly not what Congress or the White House wants to hear.

Still, the Fed remains adamant that the economy is underperforming. Hence, its rationale for throwing massive amounts of monetary stimulus at the economy — prime the pump with cheap money and it will unlock the excess capacity in the system. The Fed’s models, though, are only as good as the assumptions they’re based upon.

The critical belief that underpinned last week’s decision to keep the foot on the monetary accelerator is the idea that the U.S. economy can get back to growing at more or less the same pace as it did during the last decade. If such thinking is correct, the U.S. economy would indeed be facing an enormous output gap. Idle plants, inactive equipment and unused workers adds up to slack in the system. If that’s the culprit holding back GDP from its full potential, then certainly the Fed should do what it must to get the economy humming again. It’s a theory subscribed to by high-profile economists such as Princeton’s Paul Krugman. He can be heard exhorting the Fed to do even more for the unemployed — give jobs a chance, he asks — from the pulpit of his New York Times column.

Look around the world, though, and consider how many economies are still growing like gangbusters. Not China’s and certainly not India’s. Not long ago, those countries were the global economy’s brightest stars. Now, their growth has shifted into a much lower gear. What if the U.S. economy’s potential growth rate has also downshifted? Would the Fed’s monetary stimulus still be closing an output gap and putting millions of Americans back to work in the process? The answer is no. What all that money sloshing around the system would do, more likely, is encourage the formation of another asset bubble.

Wall Street is one place that’s definitely cheering the Fed’s policy decisions. Cheap money is making life sweet for the private equity crowd, hedge funds and dealmakers. After all, it’s easy to speculate with credit, as JP Morgan’s “London Whale” could tell you, when the cost of carrying debt is essentially nil. It bears remembering, though, that it was the free money policies of the maestro himself, former Fed chair Alan Greenspan, that spawned the subprime mortgage fiasco in the first place.

Instead of trying to pump up growth with highly speculative and potentially hazardous monetary experiments, the Fed needs to recognize that our economies just can’t grow at the same pace they once did. Better to come up with policies that grapple with that reality, rather than charge ahead with unprecedented measures designed to recapture yesterday’s growth.

Source: Jeff Rubin's Smaller World

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