The Federal Reserve has a dual legal mandate: to keep prices stable and to maximize sustainable employment. This week, the central bank is going to take a controversial step Fed officials hope will help eventually achieve both.
On Wednesday afternoon, at the end of a two-day meeting, the Fed's top policymaking group, the Federal Open Market Committee, is expected to announce resumption of purchases of longer-term Treasury securities, probably worth at least $1 trillion, according to estimates. The goal is to lower interest rates on private as well as government securities and in the process spur faster economic growth and reduce stubbornly high unemployment.
The long anticipated move, dubbed quantitative easing, or QE2, because it would be the second round of such purchases, is controversial for several reasons. Among other things, foreign officials are concerned about the effect on the value of the dollar and its impact on trade.
Since longer-term interest rates are already very low, even Fed Chairman Ben S. Bernanke isn’t sure how much difference the added large-scale purchases will make. The earlier round of Fed buying of about $1.7 trillion worth of Treasury and mortgage-backed securities that ended earlier this year did reduce rates, particularly those on home mortgages, but the lower rates led to only modest gains in the beleaguered housing market.
Opposition to QE2
Some members of the FOMC, particularly Thomas M. Hoenig, president of the Kansas City Federal Reserve Bank, oppose the move for fear it may lead to unacceptably high inflation and new asset price bubbles down the road. Other officials have expressed concern that such a large expansion of the Fed's $2.3 trillion balance sheet would make it more difficult for the central bank to pull back the extraordinary supply of cash in the banking system when economic conditions improve again.
"One disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public," Bernanke acknowledged in a mid-October speech.
And then there are the loud complaints from some foreign officials that Fed action to cut interest rates will unfairly devalue an already weak U.S. dollar, which would cheapen U.S. exports. The complaints are coming primarily from countries such as Germany, China, South Korea and Russia that have trade surpluses they want to keep.
According to Fed indexes of the dollar's value compared to groups of foreign currencies, the dollar last month was virtually the same as it was one, two and even three years ago. Super-low U.S. interest rates already have generated large flows of capital into some emerging market countries, driving up the local currency and hurting exports, officials say.
However, in the last few weeks, the dollar has dropped about 3 percent in response to the widespread expectation of Fed action. A weaker dollar could make U.S. exports more competitive on world markets, but that's not the primary purpose of what the Fed is doing.
Alessandro Giraudo, chief economist at Tradition Securities and Futures in Paris, said in an interview via email, "If the dollar goes down, this is only a secondary effect of a monetary policy decision meant at supporting a sliding economy." Besides, he added, "any recovery and possible strength of the U.S. economy may be very useful and helpful to support the world economy, for countries with and without trade surpluses."
In short, the complaints about the dollar are not likely to influence the outcome of the FOMC meeting, and the foreign officials undoubtedly understand that. Most likely, their comments have been intended to challenge Treasury Secretary Timothy Geithner's efforts to persuade nations with large surpluses that they have an obligation to correct such imbalances just as much as nations, including the United States, which have large deficits.
Edwin M. "Ted" Truman, a former director of the Fed Board's Division of International Affairs who is a senior fellow at the Peterson Institute of International Economics*, said recently that the Chinese "have been able to use this criticism to some degree to deflect the currency debate into a debate about U.S. monetary policy." He added, however, that foreign criticism shouldn’t prevent the Fed from making the Treasury purchases, which he called "a reasonably sensible policy."
At the recent meeting in South Korea of finance ministers for the G-20 countries, which include those with the world's largest economies, Geithner was successful at having the issue discussed, but hardly resolved. China, for example, which pegs its currency to the dollar, gave no indication it would allow the yuan to appreciate. Meanwhile, a number of other countries are also intervening in foreign exchange markets to hold down their currencies.
Former Fed vice chairman Alan Blinder, now a Princeton University professor, said in a recent op-ed piece in The Wall Street Journal that the Fed should go ahead with the Treasury security purchases, but he cautioned not to expect too much from it. Like others, Blinder said he worries that the second round of purchases "will not be powerful enough to move our $15 trillion economy much."
Fiscal policies such as a new jobs tax credit, direct government hiring or cuts in sales taxes or similar actions would likely have a much greater impact on the economy. For political reasons, he said, that is not going to happen.
"In a more rational world, it wouldn't be this way. Fiscal policy, which packs the power, would be doing the heavy lifting — by combining tax cuts and spending today with credible deficit reduction for the future. Monetary policy would take the back seat by keeping interest rates low,” Blinder wrote.
"But we don't live in a rational world," he said.
So on Wednesday, the Fed will do what it can — over the objections of some of its own policymakers and the complaints of others around the world.
*The Peterson Institute is funded by Peter G. Peterson, who also funds The Fiscal Times.