CAMBRIDGE – The United States Federal Reserve’s recent announcement that it will extend its “Operation Twist” by buying an additional $267 billion of long-term Treasury bonds over the next six months - to reach a total of $667 billion this year - had virtually no impact on either interest rates or equity prices. The market’s lack of response was an important indicator that monetary easing is no longer a useful tool for increasing economic activity.
The Fed has repeatedly said that it will do whatever it can to stimulate growth. This led to a plan to keep short-term interest rates near zero until late 2014, as well as to massive quantitative easing, followed by Operation Twist, in which the Fed substitutes short-term Treasuries for long-term bonds.
These policies did succeed in lowering long-term interest rates. The yield on ten-year Treasuries is now 1.6%, down from 3.4% at the start of 2011. Although it is difficult to know how much of this decline reflected higher demand for Treasury bonds from risk-averse global investors, the Fed’s policies undoubtedly deserve some of the credit. The lower long-term interest rates contributed to the small 4% rise in the S&P 500 share-price index over the same period.
The Fed is unlikely to be able to reduce long-term rates any further. Their level is now so low that many investors rightly fear that we are looking at a bubble in bond and stock prices. The result could be a substantial market-driven rise in long-term rates that the Fed would be unable to prevent. A shift in foreign investors’ portfolio preferences away from long-term bonds could easily trigger such a run-up in rates.
Moreover, while the Fed’s actions have helped the owners of bonds and stocks, it is not clear that they have stimulated real economic activity. The US economy is still limping along with very slow growth and a high rate of unemployment. Although the economy has been expanding for three years, the level of GDP is still only 1% higher than it was nearly five years ago, when the recession began. The GDP growth rate was only 1.7% in 2011, and it is not significantly higher now. Indeed, recent data show falling real personal incomes, declining employment gains, and lower retail sales.
The primary impact of monetary easing is usually to stimulate demand for housing and thus the volume of construction. But this time, despite historically low mortgage interest rates, house prices have continued to fall and are now more than 10% lower in real terms than they were two years ago. The level of real residential investment is still less than half its level before the recession began. The Fed has noted that structural problems in the housing market have impaired its ability to stimulate the economy through this channel.
Business investment is also weak, even though large corporations have very high cash balances. With so much internal liquidity, these businesses are not sensitive to reductions in market interest rates. At the same time, many very small businesses cannot get credit, because the local banks on which they depend have inadequate capital, owing to accrued losses on commercial real-estate loans. These small businesses, too, are not helped by lower interest rates.
The Fed’s monetary easing did temporarily contribute to a weaker dollar, which boosted net exports. But the dollar’s decline has more recently been reversed by the global flight to safety by investors abandoning the euro.
Even if the US economy continues to stumble in the months ahead, the Fed is unlikely to do anything more before the end of the year. The next policy moves to help the economy must come from the US Congress and the administration after the November election.
Nonetheless, what needs to be done is already clear. The cloud of a sharp rise in personal and corporate income-tax rates, now scheduled to occur automatically at the start of 2013, must be removed. The projected increase in the long-term fiscal deficit must be reversed by stemming the growth in transfers to middle-class retirees. Fundamental tax reform must strengthen incentives, reduce distorting “tax expenditures,” and raise revenue. Finally, the relationship between government and business, now quite combative, must be improved.
If these things happen in 2013, the US economy can return to a more normal path of economic expansion and rising employment. At that point, the Fed can focus on its fundamental mandate of preventing a rise in the rate of inflation. Until then, it is powerless.