Why both liberals and conservatives should hate the Fed

The Federal Reserve Bank

Most people don’t wake up in the morning thinking about the Federal Reserve System, the nation’s central bank.  Frankly, I don’t either.  But, when I think about it these days, I really hate what they’ve done to our economic prospects. 

Here’s why.

The Fed’s normal tools for modulating the economy – raising or lowering short-term interest rates – have exhausted their usefulness. Lower rates should stimulate the economy by reducing the cost of borrowing. But, when the economy wasn’t growing even with zero interest, what do you do?

Quantitative Easing (QE) was intended to stimulate the economy by supporting the acquisition of financeable assets through a policy of buying bonds like Treasuries and mortgage backed securities.  These purchases on a massive scale created low long-term interest rates with a goal of supporting the acquisition of financeable assets.  And it worked!

So, why do conservatives hate the program?  Because the increased supply of money hasn’t flowed through banks to increase the available capital for businesses to invest in growth.

Many blame the banks.  However, we should remember that we’ve told banks to cease the risky practices that led to the financial crisis.  Through the Dodd-Frank financial reform, we increased oversight of their lending activities. Also, international agreements negotiated in Basel, Switzerland required banks to increase the amount of capital they retain on their balance sheets, thereby decreasing capital available for lending. 

So, we succeeded in making banks less risky but decreased the capital flowing into the economy.  In terms an economist would use, we decreased the velocity of money. 

That’s why conservatives, read business people, hate theFed’s policy.  Growth has been floundering in the 2% range.  Take away the oil and gas boom and it would be closer to 1%.

Meanwhile, liberals -- led by the head cheerleader NY Times columnist Paul Krugman – embraced these policies.  More debt, more money in the economy the better, they said.  As for conservative fears about a collapsing dollar and inflation, we have seen no evidence.  Fools they must be, right?

Well, not exactly.  Sure inflation has been low for the last several years.  However, when viewed next to other currencies, the dollar has been weak.  And, a weak dollar increases the cost of buying foreign products.  In the last year, the Fed has ceased its bond-buying program while Europe and Japan have begun theirs.  Here’s what has happened to the dollar.

Dollar Index -- 5 year chart

What about the other effects of QE? 

The financeable assets that most benefited from the Fed’s policy have been real estate and the stock market.  Coupled with a tax code that rewards asset ownership, the policy has made the rich richer.  Liberal voices have decried income inequality without raising the connection between inequality and the Fed’s policies. 

If you want to find those most hurt by the Fed’s Zero Interest Rate Policy (ZIRP), look no further than savers who rely on interest for their income.  These include not just today’s retirees needing a low risk source of income but future retirees depending upon the success of those managing their pension funds in todays’ financial environment.

Further, policies that undermine business investment reduce employment opportunities, increase income inequality and reduce tax revenue to the government, thereby reducing its ability to fund programs that help those less fortunate. 

But, there is hope.  QE is over and ZIRP may be in its last days. And, as we emerge from a period of unprecedented Fed interference in the market, the government’s deficit has been reduced.  The end of the Bush tax cuts coupled with the cap on government spending pursuant to the budget deal struck by Congress and the President in 2011 have reduced the annual deficit.

Meanwhile, the Boston Consulting Group has projected that the US will be the manufacturing site of choice in the coming years owing to lower energy and transportation costs and favorable labor policies. 

It seems that the lesson here is: keep the government’s capital out of the market and our economy will soar.

WHO WILL LEAD?