Tim Bradley, Politics and Economics Editor

On September 18 the Federal Open Market Committee (FOMC) decided, in a move that surprised markets, that economic conditions did not yet warrant a reduction in the pace of its bond purchasing program.

The current policy of purchasing $85 billion-a-month of Treasury- and mortgage-backed securities is the third iteration of quantitative easing, a policy tool designed to maintain downward pressure on interest rates after the federal funds rate has reached its zero lower bound and other traditional policy tools have been exhausted.  These policies so far have led the Fed’s balance sheet to increase to almost $4 trillion.  After months of signaling markets to prepare for tapering due to improvements in the outlook for economic growth, the FMOC move triggered a sigh of relief in stock and bond markets, with the yield on 10-year Treasury notes falling and the Dow Jones Industrial Index closing at a record high immediately following the release of the FOMC meeting statement.

Worries about upcoming fiscal headwinds as President Obama and Congress work out agreements on the budget and borrowing limit for the upcoming fiscal year, along with lowered expectations for economic growth, led to the Fed’s decision to maintain the status quo. The nearly unanimous decision sends a strong message to markets that the Fed is committed to maintaining its accommodative policy as long as it is not satisfying its dual mandate.

Committed to maximum employment in the context of price stability, the Fed’s long-term expectation for inflation (the inflation rate they see as consistent with its dual mandate) is two percent.  The current underlying rate of inflation in the United States is 1.5 percent, and the latest data on labor shows the unemployment rate to be 7.3 percent.  In previous statements, the FOMC has indicated that an unemployment rate of 6.5 percent will be a threshold for increasing the federal funds rate (the FOMC does not expect this to happen until 2015), but that does not mean that the decision to taper its bond purchases will wait until then.

Timothy Fuerst, the William and Dorothy O’Neill Professor of Economics here at the University of Notre Dame and concurrent Senior Economic Advisor at the Federal Reserve Bank of Cleveland, was kind enough to comment on this topic.  Discussing the greatest risks associated with the FOMC’s decision to continue its current policy, Fuerst says, “At some point, the Fed will want to return its balance sheet to normal, or pre-crisis, levels.  There are many uncertainties with this process.  The problem is of course large if the balance sheet is larger.  In essence, at some point we will need to walk back out of the dark forest that we have entered.  But the further we go in, the harder it is to see the exit.”

A major contributing factor to the FOMC’s decision is the fact that inflation has been so sluggish.  One of the biggest fears of critics of the Fed’s policy is that inflation growth could become untethered due to the enormity of the Fed’s balance sheet and cripple the fledgling economic recovery.

Why, then, has inflation growth been so low?

Fuerst says, “To quote Milton Friedman, ‘Inflation is always and everywhere a monetary phenomenon.’  The expanded balance sheet of the Fed has not translated into money.  Instead, these balances are simply being held by banks as reserves.  They become money if and only if they are loaned out and make their way into the financing of transactions.  That is, the balances the Fed has created are not money…they are simply piling up as bank assets.”  The only voting member of the FOMC who dissented at the last meeting was Esther George, President of the Federal Reserve Bank of Kansas City.  George fears that those piled-up bank assets pose a significant inflationary risk, and “that an extended period of low interest rates will produce mispricing of financial assets, what some would call a bubble,” according to Fuerst.

Investors should also be cautioned not to expect the Fed to feel obligated to commence tapering or to increase the funds rate just because the unemployment rate falls to a certain level or inflation reaches a certain threshold.  Ben Bernanke, Chairman of the Board of Governors at the Fed, said in his press conference following the FOMC meeting, “We are tied to the data…We can’t let market expectations dictate our policy actions.  Our policy actions have to be determined by our best assessment of what’s needed for the economy.”  Fuerst agrees that the best policy is one “…in which policy is linked to observed macro aggregates…The timing of changes in the balance sheet should be linked to macro behavior.”

It should be noted that the continuation of this policy has little efficacy in terms of a further reduction in interest rates.  Its main purpose is to maintain downward pressure and prevent rates from rising in the hopes of spurring business and consumer investment.  On the efficacy of these programs, Fuerst says, “The evidence suggests that there are significant diminishing returns to this strategy.  These purchases are most effective when financial markets are seriously impaired, eg fall 2008.  But this is no longer the case.”

The pace of purchases will be reduced eventually; the important question now is what effect this reduction will have on the economy.  Fuerst explains, “To the extent that the purchases have kept interest rates low, a slowing of purchases should have the opposite effect.  There is some argument within the Fed whether the stock of purchases matters (the sum of past purchases) or whether the flow matters.  Most argue that the stock is more important so that a decline of purchases will have a modest upward effect on long rates.  If the flow is what matters, there will be a more significant effect on rates.”

Whenever the FOMC chooses to reduce purchases, Fuerst thinks that “surprises in policy moves should be avoided.”  The Fed may not allow market expectations to dictate their decisions, but they are mindful of the impact of their actions on markets.  Expect more and more transparency on this issue as the FOMC begins to find its way out of the dark forest that it has wandered into.

Tim Bradley is a sophomore Economics and Theology major.  He once dreamt of having a beard as fine as Ben Bernanke’s, but it was only just a dream.  Contact him at tbradle5@nd.edu.