The recent economic data leave little doubt that the economic recovery in the United States is anemic at best. There was much celebration over the November jobs report. This showed a gain of 151,000 jobs. This was better than the near-zero number anticipated by most economists, but should hardly provoke cries of joke. The economy must create 100,000 jobs a month just to keep even with the growth of the labor force, which means that it will take more than a decade at this pace to get back the 7.5 million jobs lost to date.
The picture painted by the data on third-quarter GDP, which was released the prior week, was even bleaker. Most reports focused on the 2.0 percent growth number, which was slightly higher than had been expected.
However these reports missed the fact that most of this growth was due to the extraordinary pace of inventory accumulation in the quarter. The rate of accumulation in the third quarter was the second-highest ever, adding 1.4 percentage points to growth for the quarter. Excluding this jump in inventories, the economy grew at just a 0.6 percent annual rate in the third quarter. If inventory growth returns to a more normal level, fourth quarter growth will likely be negative.
The Fed's decision to try another round of quantitative easing must be understood in this context. The U.S. economy is operating far below its potential and is not likely to return to potential output any time soon without some outside boost. The Fed's decision to buy $600 billion in government bonds over the next eight months is a step in this direction.
This is a follow up to an earlier round of quantitative easing announced at the beginning of 2009 in which the Fed bought $1.25 trillion of mortgage-backed securities and another $300 billion of government bonds. That move helped to bring down long-term interest rates and stabilize the economy at a time when it was sliding rapidly.
The new move should also help to lower interest rates; although the effect is likely to be limited. With long-term interest rates already at extremely low levels, it is unlikely that the Fed's new bond purchases will lower them much further. A decline of 30-40 basis points would probably be the best that can be expected. This would lead to a somewhat smaller decline in private sector rates, like mortgage interest rates and corporate bond rates.
This will help to promote growth, but it is not likely to qualitatively change the basic economic picture. A modest drop in mortgage interest rates will not revive the housing market nor will lower interest rates lead to an investment boom. The positive stock market response may lead to some additional consumption through the wealth effect, but here too the impact is likely to be modest.
The largest effect will likely be on the value of the dollar. With the Fed quite explicitly determined to keep interest rates low, investors are likely to seek alternatives to dollar assets. This will cause the dollar to drop, which will in turn improve the U.S. trade balance. The downward drift of the dollar is something that must happen and a second round of quantitative easing may bring the drop about sooner.
Still, the Fed's move is a disappointment. Given the severity and the duration of the downturn, $600 billion in bond purchases is a very modest measure. The more effective policy that the Fed opted not to pursue is inflation targeting. If the Fed targeted a moderate rate of inflation (e.g. 3-4 percent), it could change expectations and therefore behavior.
If businesses expected that prices for most goods and service would be 12-16 percent higher in four years, then they would be far more willing to undertake investment even in the current economic climate. A moderate rate of inflation would also help households escape from indebtedness. While their debt is fixed in nominal terms, if inflation raised wages by 15 percent then it would reduce the burden of the debt by 15 percent. This should also boost consumption and growth.
House prices should also rise roughly in step with inflation. A 15 percent rise in prices over the next four years would pull many people out from being underwater. It would add trillions of dollars to homeowners' wealth.
The Fed's holding of debt also has another benefit that has received far too little attention. Insofar as the Fed holds the government's debt, the interest payments on this debt pose no burden for the government since the interest received by the Fed is refunded right back to the Treasury. Last year, the Fed refunded $77 billion in interest to the Treasury, an amount equal to nearly 40 percent of the government's net interest payments. The Fed's decision to buy and hold debt prevents the interest on this debt from posing a burden to the Treasury.
In short, QE II, as this second round of quantitative easing has been dubbed, is a positive step in the current economic situation. Unfortunately, it is not nearly enough to fully counteract the severity of the downturn.
This piece originally appeared in the Guardian.
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