December 6, 2010

QE2 vs Stimulus 3

Citing weak consumer spending and low inflation expectations, in its November 3rd statement, the Federal Open Market Committee (FOMC) announced that:

The committee will maintain its existing policy of reinvesting principal payments from its securities holdings.  In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011...The committee will [also continue to] maintain the target range for the federal funds rate at 0 to 1/4 percent...

These purchases would bring the Fed's balance sheet to nearly $3 trillion.  As of the week the FOMC's announcement, the Fed owned more than $2.3 trillion in financial assets, including $870 billion in Treasuries.

As shown in the graphic above, the Fed began its quantitative easing in the fall of 2008 and continuously altered its assets purchase programs in order to stabilize financial markets and act a buyer of last resort of mortgage-backed securities.  To that extent, the Fed's actions were successful.  The interest rate institutions charge each other to provide overnight lending has stabilize, mortgage rates are at record lows, and short-term rates are very conducive to spending.

What kind of impact will another $600 billion in liquidity actually have?  

Critics are concerned that the Fed's actions will cause inflation to runaway as the recovery gains steam.  Others, including Kansas City Federal Reserve Bank President Thomas Hoenig, worry that an extended period of cheap money will create another asset bubble.  However, Federal Reserve Chairman Ben Bernanke defended the Fed's decision on 60 Minutes last night.  Mr. Bernanke points to the extremely low inflationary environment and continued weakness in the job market.  The aim is to keep longer-term interest rates low to stoke investment and spur job growth.

Despite all of the Fed's intervention through rate cuts and asset purchases, consumers continue to save their money and payoff debts, the housing market is still struggling to find its legs, and banks are now sitting on nearly $1 trillion of excessive reserves.

Perhaps that is why Mr. Bernanke also called for the Obama Administration and Congress to provide assistance on the fiscal side.  It would seem that the his plight did not fall on deaf ears.  Today a deal on the Bush tax cuts and unemployment aid was announced that would allow the "Make Work Pay" program to lapse and make room for a payroll tax holiday for one year.  It appears that Congress is coming around to the idea of short-term deficit spending as a means to bolster the flagging economy.

While the extension of the Bush tax cuts and the extension of unemployment benefits will certainly provide aid to a sputtering recovery, its the payroll tax reductions that have the potential to really provide a boost.  A payroll tax holiday, which was not a part of last year's $800 billion stimulus package, puts money in people's pockets instantly.  This would provide an immediate stimulus, with every paycheck, giving consumers additional discretionary dollars.  Although not currently on the table, granting payroll tax reductions to employers as well (employees and employers both pay payroll taxes) would give small businesses much needed relief.  It would also lower the cost of employment for all employers creating disincentives to further job cuts while reducing the costs associated with new hiring.  Furthermore, a payroll tax holiday for businesses would free up capital for investment and equipment purchases.

The proposed compromise, while tentative, could prove to be the final shot in the arm that the economy needs to really get going.  Prior to passage of stimulus 2 (President Bush's tax refund checks were the first dose), Nobel-winning economist Paul Krugman called for a stimulus package double the size of what was eventually passed.  He warned that the $800 billion package would not suffice.  The proposal at hand is estimated to cost $900 billion.  Let us hope that Mr. Krugman's estimations are right, and that late is better than never.

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