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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
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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
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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
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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
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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
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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
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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
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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• Later, banks repay the loans, the money is withdrawn from circulation
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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
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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
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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
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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
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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”)
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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)
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… 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
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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
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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
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But seems to be workingHousing starts, homebuilder sentiment
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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?
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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!
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Thanks for listeningwww.gregip.com
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