The fed needs to change course.

• Author: Malpass, David

This article describes the Federal Reserve's monetary policy, examines its economic impact, and discusses possible exits. Federal Reserve policy is on the wrong course: it is harming economic growth, hurting savers, damaging markets, setting dangerous precedents and misallocating capital away from job-creating parts of the economy. The Fed's September 2012 policy change, in which it announced a third round of quantitative easing (QE3), was a major increase in the aggressiveness of monetary policy and, in my view, another drag on economic growth.

The best exit strategy would be for the government to adopt growth-oriented tax, spending, and regulatory policies in parallel with a growth-oriented Fed resolve to provide sound money and downsize its role in the economy. The combination would encourage investment and hiring in the U.S. private sector. The damage from the Fed's balance sheet holdings and its imposition of zero percent interest rates would diminish, allowing the development of sound money, market-based "allocation of capital, and forward-looking private sector confidence--an expectation that the Fed would interfere less with interest rates and debt markets.

The Fed's QE3 Monetary Policy

In its September 2012 meeting, the Federal Reserve said it anticipated keeping the fed funds rate near zero through mid-2015. It approved a new program of quantitative easing, dubbed QE3, to purchase agency mortgage-backed securities (MBS) created by Fannie Mac and Freddie Mac and guaranteed by them and the U.S. government--at a pace of $40 billion per month.

The Fed also said it would continue Operation Twist through year-end in which the Fed sells shorter-term Treasury notes to buy longer-term notes and bonds. When Operation Twist ends, the market anticipates that the Fed will expand its asset buying to maintain roughly the same rate of long-term Treasury purchases.

By itself, the size of the QE3 monthly purchases is relatively small--below the monthly rates during the $600 billion in MBS purchases launched in December 2008, the $1.75 trillion in follow-on QE1 purchases starting March 2009, and the $600 billion in Treasury bond purchases in QE2. However, the Fed's QE3 purchases are large in the context of the agency MB8 market. On the Fed's announcement of QE3, the market heavily bought agency MBS, generating substantial profits for market participants and driving the MB8 price up and the yield down in anticipation of the Fed becoming a major new buyer. Mortgage rates were already very low, but the Fed's hope was to lower them a bit more to encourage the housing market and to raise the price (lower the yields) on similar securities.

In addition to shifting its large-scale asset purchases from Treasuries to agency MBS, the Fed made other policy changes in September 2012. It left its QE3 purchases open-ended in terms of timeframe and amount and made ambitious statements that it would continue to expand its QE policies until the labor market improves. The Federal Open Market Committee (2012) noted: "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency-backed mortgage securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."

The FOMC's statement also said it anticipated very low interest rates through mid-2015 and planned to delay rate hikes even after the economic recovery takes hold: "The Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens."

This pushed further into the future the rate-hike tinting that Chairman Ben Bernanke had laid out previously. Speaking of the timing of rate hikes in his July 2012 congressional Q&A, he said: "It will be a similar pattern to what we've seen in previous episodes where the Fed cut rates, provided support for the recovery, and when the recovery reached a point of takeoff where it could support itself on its own, then the Fed pulled back, took away the punch bowl" (Bernanke 2012a: 28). The most recent interest rate cycle saw a 4.75 percent cut in the fed funds rate from December 2000 to December 2001 followed by "measured" or limited 0.25 percent rate hikes every six weeks in 2004-06 (about 2 percent per year). My view is that the Fed didn't take the punch bowl away fast enough in that episode, contributing materially to the financial crisis.

The Fed policy stated in Bernanke's July Q&A was already a slower pace of rate hikes than some of the previous Fed thinking. In September 2009, Fed Governor Kevin Warsh stated that the Fed would take the rate cuts back "symmetrically," meaning move them up at the same pace as the Fed had moved them down. According to Warsh (2009), "The speed and force of the action 'ahead may bear some corresponding symmetry to the path that preceded it." Since rates were cut fast in 2008, the implication would be that at least some of the initial hikes would occur quickly once the crisis stabilized.

In combination, the Fed's September 2012 policy change was a major increase in the aggressiveness of monetary policy. The Fed approved QE3 purchases, decided to buy MBS, made QE3 open-ended based on the unemployment rate, committed the Fed to new types of asset purchase in the event the labor environment doesn't improve substantially, extended the formal zero-rate expectation to mid-2015, and expressed the Fed's expectation that interest rates would be artificially low for a considerable time after the recovery strengthens--a further postponement of rate hikes from Bernanke's July 2019. expectation of repeating earlier rate patterns and from earlier Fed references to symmetry in rate hikes.

In his September 13, 2012, press conference, Bernanke emphasized the importance of the Fed's communication techniques in the effectiveness of the Fed's tools. He said that assuring the public that the Fed will take action if the economy falters should increase confidence and boost the willingness to spend. This Fed assurance that it can protect the economy from slowdowns is often described as the "Bernanke put," a...