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Economists Gramm, Taylor: Loose Monetary Policies Pose Multiple Threats

Thursday, 13 Sep 2012 08:08 AM

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Federal Reserve stimulus tools such as bond purchases from banks that flood the economy with liquidity will threaten recovery in more ways than just pumping up inflationary pressures, economist and former Texas Senator Phil Gramm and Stanford economist John Taylor wrote in a Wall Street Journal opinion piece.

Borrowing costs can rise in an agitated fashion down the road as well.

To prop up the economy since the 2008 financial meltdown, the Federal Reserve has carried out two rounds of quantitative easing (QE), under which the Fed buys bonds like Treasury holdings or mortgage-backed securities held by banks, pumping more than $2.3 trillion into the economy with fresh liquidity to spur investing and recovery during the process.

Editor's Note: Economist Unapologetically Calls Out Bernanke, Obama for Mishandling Economy. See What They Did

The Fed has also slashed benchmark interest rates to near zero percent and rolled out other measures to kick-start recovery, which at this point, remains tepid and marked by high unemployment rates and slow growth.

Loose monetary policies arguably plant the seeds for inflation down the road, but other threats loom on the horizon.

“Inflation is not, however, the only cost of these unconventional monetary interventions. As investors try to predict the timing and effect of Fed policy on financial markets and the economy, monetary policy adds to the climate of economic uncertainty and stasis already caused by current fiscal policy,” Gramm and Taylor wrote.

“There will be even greater costs when the economy begins to grow and the Fed, to prevent inflation, has to reverse course and sell bonds and securities to the public.”

Interest rates will rise when the Fed begins unloading all of the assets it snapped up during QE, and once those bonds hit the market, debt burdens will rise as well.

“When the Fed must, in Chairman Ben Bernanke’s words, begin ‘removing liquidity,’ by selling bonds, the external debt of the federal government will rise and the Treasury will then have to pay interest on that debt to the public,” the pair wrote.

“Selling a trillion dollars of Treasury bonds on the market — at the same time the government is running trillion-dollar annual deficits — will drive up interest rates, crowd out private-sector borrowers and impede the recovery.”

Meanwhile, the unloading of mortgage-backed securities will pressure up borrowing costs elsewhere.

“The same problems will occur as the Fed begins to sell its holdings of mortgage-backed securities to reduce the monetary base. When the Fed bought these securities, it may have marginally reduced mortgage interest rates. Selling them during a real recovery will likely cause mortgage rates to rise,” according to Gramm and Taylor.

The Fed is holding a monetary policy meeting, and many economists expect the U.S. central bank to announce plans to roll out a third round of QE to counter high unemployment rates and weak demand and growth.

Hopefully the Fed will let the economy will recover on its own, the pair write.

“The benefits of a third round of QE will almost certainly be de minimis. But when economic growth does return, Fed actions will have to be reversed in an era of rising interest rates, and the marginal cost of a QE3 tomorrow will almost certainly be far greater than the marginal benefit today,” said Gramm and Taylor.

“Someday, hopefully next year, the American economy will come back to life. Banks will begin to lend, the money supply will expand and the velocity of money will rise. Unless the Fed responds by reducing its balance sheet, inflationary pressures will build rapidly.”

Other experts say further monetary easing won’t create jobs as long as fear and uncertainty over the country’s fate keep demand at bay.

“The Fed continues to want the economy to grow faster and specifically, to grow more jobs, but the ability of QE to do that is extraordinarily limited,” said Catherine Mann, a Brandeis University finance professor and former Federal Reserve economist, according to CNNMoney.

“We know that QE reduced interest rates, but we also know that has not led to more construction, more mortgages, more business investment or more lending,” Mann said, adding “since it hasn’t done any of that, it probably hasn’t created jobs either.”

Editor's Note: Economist Unapologetically Calls Out Bernanke, Obama for Mishandling Economy. See What They Did

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