The Federal Reserve’s decision to order another round of monetary stimulus (albeit a modest one) plays into the hands of critics who accuse Chairman Ben Bernanke of enabling Washington’s deficit-spending addiction.
The good news for Sen. Jim DeMint, R-S.C., and other lawmakers who share this view is they can stop the debt binge with a long-term deficit-reduction plan.
First things first: The Fed’s move, although likely to have a limited effect, is still welcome news for an economy growing too slowly to create enough jobs for the millions of Americans looking for work. The economic picture threatens to slip into reverse for the third consecutive year with gross domestic product expected to increase just 2 percent in 2012. The outlook for 2013 isn’t much better. Europe’s implosion, Asia’s slowdown and the pending withdrawal of more than $600 billion from the U.S. economy are creating stiff headwinds.
The Fed’s extension of Operation Twist, in which it will replace $267 billion in short-term debt with longer-term securities, continues its efforts to stimulate the economy by driving down interest rates. The theory is that cheap credit will spur consumers to buy and refinance homes, purchase new cars and other goods, and encourage businesses to invest and hire.
Since the 2008 financial crisis, the Fed has tried to push rates lower by snapping up Treasury securities and mortgage- backed bonds issued by Fannie Mae and Freddie Mac. After initially purchasing more than $2 trillion worth, the Fed in September began Operation Twist, which involved selling $400 billion in short-term bonds it already owns and using the funds to buy longer-term ones.
Wednesday’s move extends that program to year-end, but many economists see its effect waning. For each interest-rate reduction the Fed engineers, its ability to entice more borrowing diminishes.
One side effect of the Fed’s debt-buying spree is that it helps the U.S. government finance its budget deficit. After all, the Fed is a motivated buyer of U.S. debt — which enables all that government spending — and lower interest rates make it cheaper for the United States to borrow. The Bank of International Settlements estimates Operation Twist lowered the 10-year bond yield by 0.85 percentage point, which lowers borrowing costs for the U.S. Treasury.
This has given rise to criticism among lawmakers and some Fed officials that all this intervention is simply enabling fiscal recklessness. As Dallas Fed President Richard Fisher put it recently, there is “a growing sense that we are unwittingly or, worse, deliberately monetizing the wayward ways of Congress.”
DeMint and fellow Republican Sen. Mike Lee of Utah have proposed cutting off the spigot by capping the Fed’s balance sheet. That’s a backward way of trying to address the crux of the criticism: that the U.S. is running an outsized budget deficit. A more sensible approach, and one that will lessen the need for Fed intervention, is to couple short-term fiscal stimulus, such as an income tax rebate, with longer-term deficit reduction that cuts spending and increases revenue.
More important than relieving the Fed’s burden, fiscal stimulus would provide a bigger economic jolt because it can be better targeted than monetary intervention. As the Fed has observed, the cheap credit produced by its easing isn’t filtering down to those who need it the most.
At the same time, an anticipated pickup in productivity will make it more difficult for Fed policies to reduce unemployment, because businesses will be able to do more with existing workers.
To attack the jobs problem, the Fed would probably need to temporarily tolerate inflation slightly higher than its 2 percent target. Two percent, after all, is a target and not a ceiling. Fed Vice Chairman Janet Yellen indicated as much in a speech in April, when she warned the economy could fall into a “self-reinforcing downward spiral of economic activity” that it may not be able to stop without bold, pre-emptive Fed action.
Yet one reason the Fed isn’t more aggressive is the strong pushback from Republicans and a handful of others who deeply mistrust the central bank or think Bernanke is trying to help President Obama get re-elected.
The Fed may be making it easier for the government to finance its deficit, but the main enablers are members of Congress, who have so far proved unwilling to attack the very real problems threatening the U.S. economy. Rather than criticizing the Fed for stepping into the vacuum, lawmakers should do their part by agreeing to a compromise budget that allows for immediate economic growth and a more sustainable future.
