By Roger E. A. Farmer

According to a widely-held consensus view, the world is slowly emerging from the Great Recession of 2008. Growth in China is projected to top 8 per cent in 2009. Australia raised the interest rate on the Australian dollar last week and the US and UK economies are showing signs that unemployment growth has slowed even though the unemployment rates in both countries are very high. Sometime soon, perhaps in the spring of 2010, perhaps earlier, the Fed, the European Central Bank, and the Bank of England are likely to respond to the perceived global recovery by reducing the sizes of their balance sheets and raising interest rates on overnight loans.

John Taylor, of the eponymous Taylor Rule of central banking, foresees a welcome return to business as usual. In his view, once the Fed starts to tighten, it would raise interest rates in response to inflation and lower them when actual output falls below potential output. That would be a mistake. We can do better.

The liability side of the Fed balance sheet is a narrow measure of the money supply. Backing this up on the asset side, the Fed holds gold, foreign currencies and loans to the US government. After the demise of the gold-exchange standard in 1973, the assets of the Fed consisted mostly of three-month Treasury bills. This was true for 35 years until the Great Recession of 2008 led to an unprecedented change in monetary policy.

Central banks throughout the world began to purchase an exotic variety of new assets. In the US, the Fed bought long-term government bonds and relatively risky (by historical standards) private securities. Historically, monetary policy meant variations in the size of central bank balance sheets. In the US this was accomplished by the purchase and sale of T-bills. During the Great Recession, the Fed and other central banks learnt to vary not just the size of its balance sheet, but also its composition.

Soon, central banks throughout the world will follow Australia’s lead and begin to raise overnight interest rates. When this happens, world central banks should embrace quantitative easing as a second pillar of monetary policy, not abandon it and revert to business as usual.

Consider the case of the US. By changing the size of the balance sheet in response to inflation, the Fed can and should vary the interest rate to target inflation. By changing the composition of its balance sheet between T-bills and private securities, it can and should target the unemployment rate. This policy has not been more widely discussed until now because most economists believe that the Fed cannot do anything about unemployment in the long-run. World experience during the Great Depression, and again during the 2008 financial crisis, suggests that this view is mistaken.

As the economy recovers, economists will argue over the definition of potential output. Inflation doves will point to historically high unemployment rates and will urge a delay in raising the interest rate and a continuation of quantitative easing.

Inflation hawks will argue that potential output has fallen and the “natural rate of unemployment” has permanently increased. They will attribute this increase to the loss of skills by the recently unemployed that requires a long period of retraining. The hawks will point to the danger of renewed inflation arising from a falling dollar and rising prices for raw materials.

If the hawks prevail, inflation will be kept under control at the cost of a decade or more of high unemployment. If the doves prevail, there is a danger of a repeat of the stagflation of the 1970s, with high inflation and unemployment occurring together.

We don’t have to accept either of these scenarios. They are driven by the false assumption that monetary policy must be either tight or loose. Once one recognises that monetary policy has two dimensions, it can be both tight and loose at the same time.

Historically, the Fed has targeted the fed funds rate. A high fed funds rate is bad for the employment outlook because it depresses the values of corporate bonds and public and private equity. Investors move out of real assets that create jobs and into barren federal securities. But there is no reason for the Fed to accept a depressed market valuation for these assets.

By purchasing private securities, and paying for these purchases by issuing its own interest-bearing securities (Fed-bills), the Fed can operate on two fronts at once. To deal with inflation the Fed must make the credible announcement that it will increase the Fed funds rate to target inflation. To deal with unemployment, it must make the credible commitment that the value of private assets that are backed by productive capital will not be allowed to crash. By maintaining quantitative easing as a second pillar of monetary policy, we can have our cake and eat it too.

Roger E. A. Farmer is professor and chair of economics at the University of California, Los Angeles. He is the author of two books on the crisis, How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies, and Expectations, Employment and Prices.

Related link:

Quantitative easing explained

Tags: Quantitative easing

October 16, 2009 12:37pm in Capitalism, Central banks, Crisis, Economists, Inflation, Monetary policy | Comment