Business Perspectives

It will take time to see results of Fed's actions

The Federal Reserve has been buying some $600 billion in government bonds and paying for them with newly created money. Whether it should continue to do so is a key economic issue of the past two months. Opinions are sharply divided, even among economists, and the fault lines are not necessarily along the usual schools of thought or political leanings.

What the Fed is doing now, buying bonds, is not fundamentally different from what it does any time it lowers interest rates. But because the short-term interest rates the Fed usually targets already are extremely low, this policy is presented as "quantitative easing" rather than an interest-rate reduction.

The Fed has unofficially adopted a policy of targeting inflation rather than short-term interest rates or the money supply. Preventing deflation is the ostensible objective Fed Chairman Ben Bernanke and concurring Fed officials cite to Congress and the public.

But by choosing to buy up longer-term Treasury bonds rather than 13- or 26-week Treasury bills, the Fed also may be trying to push down longer-term interest rates, especially those on home mortgages.

Whatever the Fed's principal objective, its actions have other effects. Creating another $600 billion to buy bonds will reduce the value of the dollar relative to other currencies, all other things being equal. Other things are not equal, particularly in the battered eurozone, so the dollar has not lost much value yet, and it remains more expensive in Euro terms than at the end of 2008.

Keynesian economists, who advocate manipulating the money supply, tax rates and government spending to speed or slow economic activity, see yet another aim of the Fed's policy: to lower persistent high unemployment and spur increased output.

If the objective is to prevent deflation, the policy might be succeeding — barely. The most recent Consumer Price Index shows a slight increase over October. If that rate of increase persisted for a year, the general price level would rise by less than 1.5 percent.

But if a goal is driving down long-term interest rates, that certainly isn't happening. In fact, rates on 30-year Treasuries have drifted up since late summer. From a low this year of 3.77 in September, these rates have risen to near 4.5 percent. And in the past eight weeks, 30-year mortgages have increased from 4.19 percent to 4.61 percent.

These are still extremely low rates by historical standards, although current inflation is also low. But why are these interest rates rising rather than falling?

One possibility for the discrepancy is that "other things are not equal." Actions of officials other than the Fed can alter long-term rates. The two parties in Congress and the president have compromised on extending all tax cuts and increasing spending. If you are a Keynesian, that amounts to another stimulus package. And over recent weeks, interest rates rose in step with news about the likelihood of this outcome.

Optimistic pundits see the rise in interest rates as evidence of increasing economic health. Markets see that the government is acting to stimulate the economy, the economy will grow as a result, and there will be more demand for long-term borrowing, increasing its price. Moreover, any cheapening of the dollar that may come from the Fed's money creation will be good for any business that exports or has to compete with imports.

Pessimists look at the same picture and see increasing expectations of inflation. The government is running big budget deficits, and the most recent budget deal ensures deficits will continue at high levels. The central bank is "accommodating" the deficits by buying up bonds. History tells us this is a classic prescription for inflation, at least in the long run. People are rational, they know the probable outcomes of these fiscal and monetary policies, and they are taking steps to protect themselves.

One of the first ways of protecting yourself against inflation is to borrow long-term at fixed rates while money is still cheap. A second is to not lend money long-term unless you are well compensated for the risk of inflation. Increased demand for long-term money and a decreased supply from sources other than the Fed both push up interest rates. Pessimists see that fact that inflation remains quiescent as just a lull before a storm.

On that point, all economists know changes in monetary policy have long and variable time lags before they affect the real economy. In a year, we will see the true effects of the Fed's bond buying on prices, output and employment, but what we see now does not result from anything that happened in the past six weeks.

Too many things are happening at once for any honest economist to be sure of an explanation. We can only watch things evolve. But if long-term rates continue to edge up as Fed buying of longer-term bonds proceeds, hold onto your hat. That is the classic sign of the reins slipping out of a central bank's hands just as nervous horses become runaways.