The outlook for the American economy darkened considerably over the summer. Due to factors including Euro Zone instability, the debt ceiling fight, the end of QE2, a Federal Reserve action that increases the money supply, and the Japanese earthquake, the economy has slowed to a complete halt. Tepid job growth numbers have turned into August’s zero jobs created at all, while the annual rate of real GDP growth for the second quarter of 2011 has slowed to an abysmal rate of one percent . In light of these factors, the Federal Reserve must take bold action to revitalize the economy at its Sep. 20 meeting.
The Fed has numerous instruments to increase growth remaining in its policy arsenal. Traditionally during a recession, the Fed purchases short-term government bonds to keep interest rates low, but with short and long-term rates already at zero, this is no longer a fruitful avenue for additional policy interventions. Instead, as was seen in QE and QE2, the Federal Reserve can increase the monetary supply and keep long-term interest rates low through purchasing a variety of longer-term and unconventional assets.
Increasing the money supply and keeping long-term interest rates low increase growth through a few meaningful channels. Low long-term interest rates make borrowing less expensive and thus can increase individual financial flexibility and finance significant consumer spending. For example, low long-term mortgage rates have currently made this a great time to borrow to buy a house, or to refinance your mortgage and use the savings to spend elsewhere. Increasing the money supply increases nominal wages and thus lowers the burden of nominal debts; when your nominal wages increase from $50,000 to $60,000, it becomes much easier to pay off $30,000 in accumulated nominal loans. Finally, increasing the money supply weakens the dollar, strengthening American exports.
Right now, according to a recent Bloomberg article, “in per-capita terms, nominal GDP is actually below where it was at the start of the crisis.” This is a clear sign that the Federal Reserve must dramatically increase the money supply, and another, larger, set of asset purchases, QE3, could effectively achieve these ends. Economist Joseph Gagnon has estimated that $2 trillion in asset purchases would have a comparable effect to $500 to $800 billion in fiscal stimulus.
An effective policy to couple with asset purchases would be a commitment to take all policy actions necessary until inflation hit a certain target, such as four percent, or unemployment hit a certain target, such as five percent. Charles Evans, a member of the Federal Open Market Committee and president of the Chicago Fed, recently suggested a similar idea, arguing for a statement that the Fed would take aggressive action until unemployment reaches seven percent or inflation reaches 3.5 percent. By setting an aggressive target and clearly conveying it to the public, the Fed would send a message to the businesses and consumers that they should spend their record cash reserves and expect loose policy, because inflation will steadily increase until employment has reached acceptable levels.
Finally, the Federal Reserve must stop paying interest on bank reserves. This measure was taken during the financial crisis to encourage banks to build reserves, and the policy, which pays banks to keep cash in reserve, is surely a significant incentive for banks to hold onto cash instead of to lend it out to businesses and consumers. Critics argue that this could result in the same type of risky low reserves that existed before the financial crisis, but the combination of stricter financial regulation laws and strengthened capital requirements are sufficient and more effective tools to keep the financial system safe than paying interest on reserves, which is giving banks an incentive not to lend money.
There is a small but loud set of politicians, commentators, and economists that is exerting massive political pressure on the Federal Reserve not to take any further action. A few inflation hawks on the FOMC argue that additional policy measures pose an undue risk of inflation, but current inflationary pressures are mostly driven by Asian commodity demands, and realistically, the country can afford much more inflation. During the 1980’s, core long-term inflation hovered around four percent, and there’s no reason that the economy can’t thrive with modest inflation.
Many politicians also strike the populist argument that increasing the money supply is a debasement of the currency and a striking moral offense. Yet we are nowhere near dangerous hyper-inflation, and currency policy is a tool to keep the economy growing steadily. During recessions, a slight devaluation of the currency increases American exports and strengthens consumer spending; while during a boom, a slight strengthening of the currency will dampen economic growth and keep the economy from overheating. The only morality judgment that should be made of currency policy is whether policymakers are doing everything in their power to end the tragedy of mass unemployment and get Americans back to work.