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The Fed's Stimulus Is a Chimera

June 27, 2014 in Economics

By James A. Dorn

James A. Dorn

The U.S. Federal Reserve Bank’s three rounds of quantitative easing and near-zero target for the federal funds rate have not provided the promised stimulus. The idea that dramatically expanding the Fed’s balance sheet and rapidly increasing the monetary base would revitalize the real economy is a fantasy. Printing fiat money does not lead to economic growth.

By keeping short-run interest rates near zero and using large-scale asset purchases to suppress longer rates, the Fed has increased risk taking, depressed saving and investment, allowed monetary policy to grease the wheels of big government, and misallocated capital.

Low rates have reduced the velocity of money, and the Fed’s policy of paying interest on excess reserves, along with stiffer banking regulations, have substantially lowered the impact of base money on the overall money supply. Consequently, even with the so-called stimulus, nominal income has been growing below trend.

The Fed has been consistently wrong in its economic forecasts, typically being overly optimistic about what its monetary fine-tuning can achieve. The U.S. economy is simply too complex to accurately forecast. Basing the path of monetary policy on pure discretion runs the risk of destabilizing markets, in contrast to a rule-based regime that reduces uncertainty.

With the mushrooming of the monetary base but little inflation, some pundits are arguing that the pressing issue is to avoid deflation and achieve higher inflation. The Fed’s target is 2 percent inflation, but economists like Kenneth Rogoff at Harvard have advocated pushing inflation to 4 percent, with the hope that higher inflation will lower the rate of unemployment and increase spending and growth. Have they forgotten the stagflation of the late 1970s?

The vast majority of policymakers advocate keeping interest rates near zero for “a considerable time.” Many admit there is a risk of creating asset bubbles, but they downplay that risk and largely ignore the negative impact on savings. One exception is Kansas City Federal Reserve President Esther George who recently stated: “My concern is that keeping rates very low into late 2016 will continue to incentivize financial markets and investors to reach for yield.”

The U.S. central bank should start to normalize rates, but that would cut off the government from its source of cheap financing.”

David Wessel, director of the newly established Hutchins Center at the Brookings Institution, which focuses on monetary policy, argues that “too much inflation is definitely bad for an economy, but so is …read more

Source: OP-EDS

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