It is too early to make a definitive call, but so far the Federal Reserve's (Fed) efforts to stimulate economic activity through quantitative easing has not been effective as noted by this December 10th, 2010 Wall Street Journal piece written by Jon Hilsenrath and Mark Whitehouse. Quantitative easing is a process where the Fed issues short-term U.S. Treasuries to the marketplace and uses its sale proceeds to purchase longer-term U.S. Treasury bonds in an attempt to drive down interest rates on borrowing and investment. Even though the Fed's action by itself was supposed to lower interest rates, separate market forces are counteracting their efforts, so far.
Surprisingly, long-term interest rates have risen sharply. This is not good because this increases the borrowing costs for investors and homeowners. Therefore, it is less likely for us to receive a boost in investment spending or reverse the slide in housing prices. When investment spending is on the upswing, that means that businesses are more likely to create jobs. As for housing, a rise in prices will increase overall wealth and that is usually followed by more consumption spending, which is the main driver for economic growth.
One reason that long-term interest rates might be rising is due to anticipated acts from Congress. First, the markets are anticipating that legislation extending the Bush tax cuts will take place before the end of the year. In addition, this legislative piece is also expected to stimulate the economy with its mixture of tax breaks and a reduction in payroll taxes. Both components are expected to boost economic activity, so investors believe inflation expectations might rise. The reason for this is because firms will be anxious to raise prices once the economy picks. Lastly, continuing the Bush tax cuts, along with other stimulants, will increase the budget deficit. In fact, the cost of this proposed package will probably exceed the $787 billion tab of the American Recovery and Reinvestment Act of 2009.
The expected decline in the dollar has not yet materialized and that is vital to increasing U.S. exports. U.S. exports are goods produced domestically, but sold abroad. When exports rise, this means more jobs here. As our students learn in Principles of Macroeconomics and Mankiw's Open-Economy Macroeconomics: Basic Concepts, increasing money supply will decrease the U.S. nominal exchange rate. However, we can see that after declining for most of 2010, we are starting to see the U.S. dollar appreciate over the last month, as shown by the chart on the upper left-hand corner from the New York Federal Reserve Bank..
Also when the Federal Reserve implemented QE2, it was expected that money supply would increase substantially, but we have not seen that yet. While October's M1 and M2 has grown over the last 12 months according to the charts from the New York Federal Reserve Bank, both growth rates were moderate at around 4-6%. That is low when one sees that money growth rates were almost as high as 40% in 2008. Certainly, the instability of Europe as fiscal weakness in Greece, Portugal and Ireland are causing investors to be more comfortable with the U.S. dollar.
Another effect of European turbulence is investors turning to the U.S. stock market. We have seen improvement in U.S. stocks, so that is leading investors to sell U.S. bonds and reinvest them into the stock market where they can earn a higher rate of return. That could be another reason why long-term bond yields are rising.
Overall, it is too early to make final assessments on QE2, but it does appear that its impact will not be substantive. Even though we have not seen the negative effects of inflation, it remains risky to rely on monetary policy tools for an extended period of time. We should also point out that long-term interest rates were already relatively low and economic activity was subdued. Therefore, fiscal policy should have a much stronger impact and that's why passage of the this bill is important. When an economy is struggling, it is neither prudent to raise taxes or cut government spending if you want the economy to grow soon. However, the time frame for being able to pursue aggressive actions on the economy is quickly diminishing. Otherwise, we will soon be forced to confront a burgeoning budget deficit that will require economically debilitating tax increases and government spending cuts. When this time arrives, it will be better if the economy is on more stable footing than it is now.
No comments:
Post a Comment