David Katsnelson, Senior Economist, Macroeconomics, RISI
Aug. 27, 2012
With US economic numbers showing an economy slowing or not growing quickly enough to generate growth sufficient to increase employment, speculation has again turned to whether the Federal Reserve will step in with another round of unconventional monetary easing -- QE3. Equities markets seem to believe that the Fed will provide more liquidity, rallying on bad news with the hope that it will be enough to spur the Fed to more action. However, we do not believe that the central bank will undertake another round of quantitative easing for a number of reasons, the primary ones being that it would do little to help the real economy and that the risks outweigh the rewards.
The data over the past few months have been rather mixed. Employment data for the second quarter, a key indicator for the Federal Reserve as promoting employment is one of their mandates, was very weak and increased calls for some type of action. July's employment report, on the other hand, showed strong growth in the headline number. Industrial production, as well as retail sales, had a very similar pattern, with very weak results in May and June followed by some strength in July. In general, most indicators are showing below-trend growth, but not a recession, and the economy is simply not bad enough to warrant additional support from the Federal Reserve.
More importantly, it is unclear how much of a positive effect previous unconventional Fed policy measures have had on the real economy, and it is even less clear what additional quantitative easing would accomplish. Having already pushed interest rates to zero, and with no practicable way to reduce them below that threshold, the idea behind QE was to increase the money supply by purchasing assets from banks with money that the Fed creates out of thin air. The banks would then loan out those excess reserves, money would start flowing in the economy again and economic activity would increase. Unfortunately, this has not worked out quite as it was planned. The supply of money in the system certainly increased, and banks' reserves swelled, but the second part of the plan -- to have that money start moving through the economy -- has been very slow in coming. Banks, whose balance sheets were seriously hurt by the 2008 financial crisis, simply took those greatly enlarged reserves and left them on deposit with the Federal Reserve to collect a risk-free 0.25% that the Fed was paying.
Banks were, and continue to be, reluctant to lend, preferring to repair their balance sheets by collecting risk-free interest, however small, and businesses and consumers remain reluctant to borrow due to the uncertainty in the economy or in their own financial situations. In effect, the second component of QE -- the transmission mechanism whereby the money gets from banks to businesses and consumers -- is damaged. The clearest metric of this is the velocity of money -- the number of times one dollar is used to purchase goods and services. Since the financial crisis, this indicator has been falling dramatically, and at this point is the lowest it has ever been -- lower even than during the Great Depression -- even as excess reserves have risen and stayed at high levels. Given that money is simply not moving around the economy, it is difficult to see how just adding more money to the system will change this dynamic. Lowering market interest rates will also probably not have much of an effect. The 10-year US Treasury bond is currently trading with a yield of 1.85%, up from the July low of 1.43%. The idea that pushing down this rate by 25 basis points or so, which is an estimate of the effect of another round of quantitative easing, would spur consumers and businesses to borrow more is highly doubtful.
This is an excerpt from a full story that is available in RISI's Pulp & Paper News Service. Sign in to view full story. Not a subscriber? Try it free!
- David Katsnelson, Senior Economist, Macroeconomics, author of the Monthly Economic Commentary, works out of RISI's Bedford, Massachusetts, office and can be reached at email@example.com.