Monetary policy, the Fed & QEA primer

Remarks by Greg Ip

U.S. Economics Editor, The Economist

To the Capital Markets Initiative

sponsored by Third Way

Why do we have money?

• It’s a store of value (examples of things that act as store of value: property, stocks, bonds, gold)

• It’s a unit of exchange (examples of things that act as units of exchange: wampum, gold coins, frequent flyer miles, bitcoin

The BCB era (before central banks)

• Money either consisted of coins made from specie (gold & silver) or banknotes convertible on demand to specie – a gold or silver standard

How the gold standard worked

A bank, in normal times

Liabilities Assets

$9 notes or deposits

$9 of loans

$1 shareholder equity

$1 of gold

$10 total $10 total

That same bank, boom times

Liabilities Assets

$13 notes or deposits

$13 of loans

$1 shareholder equity

$1 of gold

$14 total $14 total

Credit, money supply expand 40%, result: inflation

The problem with gold standard

• If only a few people convert their deposits to gold, no problem.

• If many people want to convert their deposits to gold, big problem – not enough gold to go around

• Banks call in loans, stop repaying people their gold• Everyone rushes to get their gold back. Result: panic!

And bank failures• Bank panics in 1797, 1811, 1813, 1816, 1819, 1825,

1837, 1847, 1857, 1873, 1884, 1893, 1907

Bust

Liabilities Assets

$7 notes or deposits

$8 of loans

$1 shareholder equity

$0 of gold

$8 total $8 total

Credit, money supply shrink 40%, result: deflation

Solution: a central bank

• In 1913, Congress creates Federal Reserve to supply an “elastic currency”

• When banks run short of cash, they can borrow from the Fed

• The Fed “prints” money, lends it to banks, in exchange for collateral,

• Later, banks repay the loans, the money is withdrawn from circulation

The Fed’s two roles• #1 Lender of last resort: to lend to solvent banks

that are temporarily short of cash, to prevent panics and unnecessary failures.

• Problem: hard to tell when a bank is actually solvent. Result: Depression

• #2 Monetary policy: regulate the overall supply of credit to prevent recessions and control inflation

• Problem: hard to know when the economy is growing too fast or when inflation is going to rear up. Result: 1970s

What causes inflation?• Monetarist view: • Fed prints money => too much money, too few goods =>

inflation• Wrong! Fed doesn’t control all the money supply: only a

tiny bit, just enough to control the “Fed funds rate”• Modern view of inflation:• Fed keeps interest rate low => more spending, less

saving => spending exceeds economy’s ability to supply goods => inflation

• If people expect higher inflation, they will set prices and wages accordingly and it will be a self-fulfilling prophesy

• This is how ALL central banks view inflation nowadays

What causes unemployment?

• In the long run, supply: the structure of the economy: demographics, labour market rules, skills/technological change

• In the short run, demand. If spending rises but does not exceed the economy’s supply, more people will get jobs, unemployment will go down

• In spending rises and exceeds the economy’s supply, only a few more people will get jobs; the rest will get higher wages, and inflation will result

Conventional monetary policy

• If demand is falling and unemployment is rising, the Fed lowers the short-term interest rate

• This also lowers bond yields as investors adjust to expectations of lower rates for a while

• Result: more borrowing, spending, less saving, higher employment

• Other effects: higher stock prices => wealth effect => more spending, investment

• lower dollar => more exports

Unconventional monetary policy

• Economy in really bad shape, people respond less to lower interest rate because they can’t qualify for loans or want to rebuild savings

• Result: short-term rate falls to zero and stillnot enough to get spending up, unemployment down

• Solution: reduce long-term rates. How?• Words: Fed says it will keep short-term rate lower

(affects bonds yields)• Actions: Fed buys bonds, directly lowering bond yields• How does it pay for bonds? By selling treasury bills

(“Operation Twist”)• Or by printing money (“quantitative easing”)

Does QE cause inflation?Printing money causes inflation only if the money

is lent & spent …

6.50

6.70

6.90

7.10

7.30

7.50

7.70

7.90

2008 2009 2010 2011 2012

$tr

n

0.0

0.5

1.0

1.5

2.0

2.5

3.0Money supply(right axis)

Bank credit (left axis)

… or if expected inflation rises

-1.5-1.0-0.50.00.51.01.52.02.53.03.5

2008 2009 2010 2011 2012

Expected inflation

Real bond yield

Does QE reduce unemployment?

• It should, with these caveats:

• Buying Treasury bonds may reduce the cost of borrowing for the government, but not necessarily for corporations and homeowners

• When corporations’ bonds yields decline, they may simply refinance debt, buy back stock, not invest

• Directly reducing mortgage yields by buying mortgage securities directly helps homebuyers

• But many homebuyers can’t qualify for a new mortgage

A lot of QE benefit swallowed upGap between mortgage rate paid by homeowner,

and yield on mortgage bond

Source: http://www.newyorkfed.org/research/conference/2012/mortgage/primsecsprd_frbny.pdf

But seems to be workingHousing starts, homebuilder sentiment

What could go wrong?

• Sustained low yields could produce more risk taking, bubbles

• Solution: better regulation

• It may be hard for the Fed to undo QE, and thus control inflation

• Solution: raise short-term interest rates

• Reduces pressure on President, Congress to reduce the deficit

• Solution: How about a fiscal cliff?

Shameless self promotion

• Thinking citizen’s guide to the economy

• Clearly written, examples, anecdotes

• No Greek letters or charts.• Not a crisis book• Does explain origins of crisis,

and its consequences• Journalism, not ideology• Useful: explains economic

indicators and economic concepts

• Little: half the size of most hard cover books. And short!

Thanks for listeningwww.gregip.com

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