The Fed is officially holding policy steady, but it looks like they have been tightening to me, even though interest rates have not risen. In this post I'll offer a short explanation of "quantitative easing" and its opposite, quantitative tightening. Then I'll offer the evidence that they have been tightening. Finally, I'll tell these very smart people how to do their job (while trying to retain a small shred of humility).
What is Quantitative Easing?
Old fashioned Keynesians always thought of monetary policy as a change in interest rates. Monetarists thought of monetary policy as changes in the quantity of money. In the past two decades, changes in financial and banking processes made interpretation of the quantity of money more difficult, so even monetarists interpreted the Fed's policy in terms of changes in short-term interest rates, primarily the Fed Funds rate.
However, this doesn't work near zero interest rates. Japan had very low interest rates, but deflation meant that real interest rates (interest rates minus inflation) were not low. After many years of foundering, they began increasing the money supply. This was called quantitative easing, and it got the Japanese economy moving, albeit temporarily.
The Federal Reserve went into massive quantitative easing in the autumn of 2008. After the Fed Funds rate fell below one quarter percent, that was all they had left in their ammo box. But now, things look different.
Evidence for Quantitative Tightening
The Fed implemented quantitative easing by buying massive amounts of debt other than their usual short-term treasury bills. They bought long-term bonds, and especially mortgage-backed securities. Here's a picture of their total credit provided to the economy.
The huge increase is apparent, but not much has been happening lately. In fact, over the past four weeks total credit has declined.
Federal Reserve credit is not the whole story, because it does not necessarily get translated into increases in the money supply. So let's look at the two most popular measures of the money, M2 and MZM. (Click those links for definitions and data.)
M2 certainly jumped in late 2008, but has risen by only 1.7 percent in the past 12 months, just keeping pace with inflation, providing no additional money for real growth. M2 declined in three of the last five months, though it did bump up in May.
MZM similarly grew rapidly in 2008, flattened out last year, and has declined for four of the last six months.
The economy is not showing the strong growth, nor the inflation pressures, that we associate with easy money. In fact, the Fed has been tightening a little bit–call it a snugging if you wish–so far this year.
Some years back the Fed dropped its impenetrable communications style and began explaining what it was doing with interest rates. It's still telling us about rates, but not about quantitative tightening.
What the Fed Should Do Now (June 2010 edition)
I have been in the camp that the Fed should get ready to tighten, but I think I was wrong (much as it pains me to admit this). The economy has substantial weakness, with 9.7 percent unemployment and factory utilization at 71.9 percent of capacity (a normal range is 78 to 84 percent). GDP is growing, but only a little faster than productive capacity is growing. We stand six to eight percentage points below a reasonable level of GDP.
Even worse, no one is forecasting a closing of the gap! The consensus forecast has growth that would only bring inflationary pressures several years from now. If you look at the individual economists who contribute their forecasts to the Wall Street Journal, the most optimistic are seeing 4.2 to 4.4 percent growth this year, and 4.4 to 4.7 percent growth next year. If the most optimistic forecasters are right, we'll still have several percentage points of slack in the economy at the end of 2011.
The Fed should ease quantitatively. It certainly is too soon to be tightening, either by quantitative means or by raising interest rates.
Will that fuel inflation fears? The financial markets currently allow the United States Treasury to borrow at very, very low interest rates. When markets start showing some fears about inflation, that will be an early sign that the easing should be stopped. Until then, let the money flow.