Fed Adds Reversal of QE to Raising Base Rates

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Public Policy

The facade of the Federal Reserve Bank. Aaron Kohr/Adobe Stock

Economists rarely agree on much, but the current debate on whether to raise the U.S. Federal Reserve’s base rate and to reverse quantitative easing is generating more disagreement than normal.

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One of our favourite economic journals, the Economist, argues in an article last week that the Fed’s narrow focus on a 2% inflation rate is proving detrimental to encouraging productivity growth in the U.S. economy.

Citing numerous sources of research, the paper suggests a more relaxed, less rigid limit would allow the Fed to take its fixation off the current low level of unemployment and refrain from holding back future growth as a result of further rises in the base rate.

The headline unemployment rate of 4.3% is the lowest in 16 years, and stands at levels that in previous recoveries would already be fueling wage rises and inflation. Yet despite unprecedented levels of quantitative easing and only just off record low interest rates, inflation has remained benign (to the consternation of economists far and wide).

Having increased rates three times in the last six months, the Fed is not only intending a further rise this year, Chairman Janet Yellen indicated in a report last week that the Fed intends to begin shrinking the balance sheet caused by quantitative easing by the end of this year at the latest and possibly as soon as September.

Initially, the plan is to start asset sales at a modest $10 billion dollars a month, increasing in steps each quarter until it reaches $50 billion a month, according to a report in the Telegraph.

The combination of increasing base rates and the withdrawal of dollar liquidity through bond selling would have a profound impact global impact.

The announcement elicited a response from Ben Bernanke, Yellen’s predecessor as chairman of the Fed. He urged the Fed to allow the economy to grow gradually into the 4.4 trillion Bond portfolio and not to take the risk of reversing quantitative easing too soon. The worry is that is the pincer movement of firmer rates and withdrawal of liquidity would prompt a stall in the global recovery, potentially pushing the U.S. back into recession.

The Fed has very little room at current interest rate levels to cut rates in the event of another recession. Last time it had 4.75% plus QE — at this point it has just 1% and a full QE balance sheet. How would it cope?

Professor Tim Congdon, founder of the Institute of International monetary research, is quoted in the Telegraph as saying if the Fed really goes ahead with reversing QE there will be trouble three to six months later, and the economy could tank in 2018.

That may be a worst-case scenario, but it does illustrate the polarization of views and underlines the fact we are in uncharted territory. No central bank has ever created such a huge balance sheet as the Fed following the last financial crisis and, honestly, they have very little idea of what impact unwinding it will have.

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The law of unforeseen or unintended consequences looms large and suggests a little more flexibility around inflation may be a price worth paying to allow time to more gradually return the finances to “normal.”

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