So Where Do We Go From Here?
Last week, in my blog, I discussed my concerns regarding the policies that the Federal Reserve has been pursuing lately. My concern was that in its attempt to achieve maximum employment, it might lose its grip on both of its mandates: price stability and maximum employment. Because reserves (or the monetary base), as things stand right now, is really large, the likelihood that there would be an inflationary pressure on the dollar, should robust lending begin, is very high. The question then becomes what policies can the Fed take to avert the inflationary pressure on the dollar, once it unleashes its ugly head, as it almost certainly would? I would like to make some few suggestions as to what the Fed can do.
The first thing it can do is to discontinue its so-called Quantitative Easing measures immediately. The reason is because the economy is picking up steadily, and the last thing we want, given our unfriendly predicament, is more money pumped into the economy by the Fed, besides the amount already available. (That only makes our work of fighting inflation harder.)
More importantly, the Federal Reserve, in its attempt to prevent inflation should not only look at the supply side of the equation, but it should take a look at demand as well. What do I mean by this: when crisis began the Federal Reserve took (and is still taking) several very questionable steps—creative though they are—in order to, in their view, avert a catastrophe. A few of them included the TAF (treasury auction facility), open market purchases, and even lending to non-banking institutions. This has created a situation where the Fed’s balance sheet has been tremendously expanded. It is not following the supply and demand dynamic anymore, because the supply of reserves by the Fed, as things stand right now, far exceeds the demand. And this has led to a situation whereby, if the Fed doesn’t pay interest on reserves interest rates would effectively be zero. Thus by, currently, paying a .25% interest on reserves, the Fed has created a, somewhat, virtual floor on interest rates, in order to prevent it from going to zero. The problem with such a compromised balanced sheet is that should robust lending begin there would be so much liquidity in the system that inflation would inevitably ignite and spread like fire in grass. So the Fed has a very careful balancing act to follow if wants to fight inflation, and reestablish the supply demand dynamic.
One option it has is to pay a bigger interest rate on bank reserves to discourage the banks from lending. The problem with this option is that it only staves off the problem for a while without having any effect on the supply and demand dynamic or the money supply, for that matter, in the long term. Another option it has, which is pretty popular with most people, is to do open market sales. The problem with this option is that if large sales are made(which the Fed has to, if it wants to meaningfully affect interest rate) at once it could lead to an abrupt reduction in liquidity, and abruptly high interest rate, which, in turn, could lead to a sharp contraction in economic activity, and even a potential deflation. So using open market sales to fight inflation would require the Fed to see it(inflation) from afar and carefully make the sales in such a way that it is not all at once, or extremely large; but rather gradually and carefully.
The next option, which is my favorite option, is for the Fed to do a combination of couple of things: My first suggestion is that it sets out a time limit within which it would slowly, but surely, take out the excess liquidity in the system through open market sales. This would help prevent abrupt contraction. Second, I would suggest that the Fed takes off the ceiling created by the discount rate, or at least raise it substantially higher. (Since when did ceilings become a good thing, anyway?) This would allow for financial institutions to bid up the cost of borrowing, which would, in turn, increase the Fed-funds rate (the same way reducing the supply of reserves would). But one thing about this approach is that, it looks at the demand side of the curve, as well, while still allowing for some liquidity in the system. One last thing it can do—although, sparingly, and only in combination with the afore-mentioned policies– is to increase the interest payment on reserves. This would allow banks to still be incentivized to lend because of the increase in interest rate that would result from the combination of the first two policies. On the other hand the cost of borrowing would not be excessively high, if the Fed takes this approach, since banks—because they would be earning good interest on their reserves—would encourage borrowing by not charging very high interest rates. This approach seem to me to be very good, since it would reduce the supply of money in the system, although not abruptly, without painfully raising interest rates.
Despite all these, we still might not be able to escape the evil jaws of inflation. My hope is that, through some very carefully circumscribed mechanisms we do.
