Why the Fed's Policies Are Increasingly Ineffective

The quantitative easing program was started in order to bail out the banking system after the 2008 financial crisis, but the Federal Reserve continues to print money even as the economy rebounds. It hopes to spur inflation, in order to stimulate demand and boost job creation.

Indeed, in many segments of the economy growth has quickened and prices are rising—and in some cases going through the roof. But overall inflation remains nonexistent and the labor market is still weak. The good news is that inflation, the scourge of the 1970s, is dead. But as the Fed persists in its attempts to beat the dead horse, it risks unbalancing the financial system.

The Fed’s emergency measures to buy mortgage-backed securities in November 2008 were justified, because after the collapse of Lehman Brothers, financial markets seized up and the global banking system was suddenly under threat. QE2, initiated in late 2010, was also justifiable, given the second leg of the financial crisis, which was impacting Europe at a time when the U.S. economic recovery was still fragile.

But the continuation of quantitative easing into 2014 is hard to explain. Bank profits are surging: The six largest of them earned $76 billion last year, only marginally less than the record $82 billion earned in 2006, with JPMorgan alone making nearly $18 billion.

Dual Mandate

Economic growth in the United States accelerated to 4.1% in the third quarter, certainly very respectable, and this year’s prospects for the U.S. and the rest of the world are looking up. The Dow Jones Industrial Average and the S&P 500 are at record levels, underpinned by healthy earnings and massive cash holdings in the corporate sector. Immediate international threats to the world economy have mostly dissipated. For the first time since 2008, political and business luminaries gathered in Davos, Switzerland, at this year’s World Economic Forum were able to shift their focus from economic crises to a more abstract topic of income inequality.

Nevertheless, the Fed funds rate has been kept at zero and quantitative easing actually accelerated. Even after “tapering” began, the Fed continued to provide liquidity at a $900 billion annual rate. If QE1 was an unprecedented measure adopted in an emergency, extreme monetary ease in an environment of steady economic growth—and enduring fiscal deficits—is an unprecedented situation that flies in the face of economic science.

The Fed’s two-pronged mandate requires it to promote price stability and to pursue full employment. While the Fed has created over $3 trillion in new money since 2008—its balance sheet reached $4 trillion in mid-January—consumer price inflation hovers around 1.5%, below the Fed’s 2% target. Since 2009, the personal consumption expenditure deflator, which the Fed favors, rose by a mere 8%. An argument can be made that QE is barely preventing deflation from taking hold in the economy, and that falling prices are a far more serious threat to price stability and the health of the financial system than inflation.

Meanwhile, the labor market remains sluggish by all measures. Job creation, never robust by the standards of past recoveries, petered out in late 2013. The decline in the jobless rate has been the result of a shrinking labor force, and the number of civilian jobs is yet to reach the level before the 2008 crisis. Actually, the ratio of payrolls to adult population among adults has been steadily falling over the past year, reaching 42.9% in December, the lowest since early 2011.

Lack of inflationary pressure after five years of quantitative easing has convinced the Fed that it can continue with the policy indefinitely. Paradoxically, without higher inflation the economy will probably continue to move sideways. On the other hand, in those sectors where price increases have been substantial, economic activity also picked up.

Home prices rose at their fastest rate since 2006 over the past year, prompting a warning from 2013 Nobel laureate Robert Shiller that the real estate market may be in the early stages of another bubble. Nevertheless, rising house prices reawakened the construction industry, creating jobs and boosting sales of home building materials and pickup trucks. The Fed would like to duplicate this model on an economy-wide level. Higher inflation—and inflationary expectations—would send consumers into the shopping malls and help the job market. A further benefit of a period of higher inflation would be to reduce the real value of government debt and allow the Fed to ease out of QE without disrupting the markets.