So Fed chairman Ben Bernanke finally pulled the taper trigger this week. And it was the right thing to do.
Stocks soared. And even with some backing-and-forthing, gold, commodity indexes, and the dollar were basically stable. In other words, financial markets approved — especially stocks, where investors believe Bernanke is telling them the economy is strong enough to weather a pullback in Fed bond buying. Actually, if the Fed shaves $10 billion in bond purchases at each of its next seven meetings, QE3 will end in October 2014 — or perhaps sooner if the economy holds up.
In truth, this bond-buying business has outlived its usefulness. The Fed’s balance sheet under QE3 (and earlier QEs) ballooned to $4 trillion, with about $2.3 trillion in excess reserves. The best that can be said of all this Fed activism is that the central bank supplied — even over-supplied — enough liquidity to meet the voracious demand for money by banks, consumer households, and others who are still deleveraging and remembering the financial crash in 2008. The worst that can be said is that the Fed dug itself into a hole that will be hard to exit in the years ahead.
I agree with market monetarists like Michael Darda and Jim Pethokoukis that the Fed’s aggressiveness has given the U.S. better recovery performance than a money-stingy Europe. But the case for QE is not open and shut.
In the past year, thanks to Fed bond-buying, the monetary base grew by 39 percent. But the broad money measure known as M2 increased by only 6 percent. So really, the claim that the Fed was ballooning the money supply is simply not true. The Fed’s money multiplier has broken down. In fact, it is not clear that QE bond buying had any effect on the money supply at all, with M2 growing at about 6 percent for years. And with the velocity, or turnover, of money also broken down, nominal GDP growth has averaged 4 percent for years.
The good news is that there is no inflation. That’s largely because those excess reserves at the Fed have not circulated through the economy. Milton Friedman, the father of monetarism, would never have thought $4 trillion in new high-powered money wouldn’t affect either the money supply or the inflation rate. But these are strange times.
And, by the way, what’s wrong with a zero inflation tax for un-indexed capital gains and consumer incomes?
Meanwhile, just as Bernanke launched what will turn out to be a longer-term tightening cycle, he sugar coated it by emphasizing a zero fed funds rate that could go on for two more years. This is the easy-money forward guidance that the central bank hopes will offset a tightening of monetary-base growth. The Fed will not be bound by a 6.5 percent unemployment-rate threshold.
Of course, Fed forecasts are just as subject to error as predictions from the rest of us. And there are no real guarantees about the future duration of a zero interest rate. But again, at least the stock market believes easy money will be around for a long time.
I’m not so sure about this. But as a free-market guy, I’ll be paying close attention to the behavior of medium- and long-term interest rates, along with gold, commodities, and the dollar exchange rate.
Which brings me back to my constant complaint that the Fed essentially has no rules. This creates confusion and uncertainty, which in all likelihood damages the economy. The Fed hardly ever looks at sensitive market prices such as gold, commodities, and the dollar. Nor has it adopted any new rules around nominal GDP or total spending in the economy. And it seems to have thrown out the Taylor rule, which essentially is an inflation target.
Basically, the Fed has become a central-planning agency that does what it wants when it wants, and will not be subject to the discipline of rule making. Over time this can come to no good.
Anyway, rising tax rates and the high-cost Obamacare mish mosh of regulations are the real factors holding back growth. So let’s have the Fed keep money value and King Dollar stable. And then let’s repeal Obamacare and reform taxes and regulations to reignite supply-side incentives for growth.
– Larry Kudlow, NRO’s economics editor, is host of CNBC’s The Kudlow Report and author of the daily web log, Kudlow’s Money Politic$.