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Policy at a Crossroads

October 25, 2012

Even as interest rates have declined, bank lending standards have tightened, particularly impacting individuals and small businesses. In other words, the money injected into the system by the Fed has not translated into credit creation as many financial institutions are more than happy to park excess cash in Treasuries.
-Investment Strategy Group, Neuberger Berman

On September 13, the Federal Reserve announced a third round of quantitative easing, dubbed QE3, in the hope of providing an additional boost to the slow U.S. economic recovery. Although this latest policy action reinforces the notion that the U.S. is prepared to support its economy for as long as needed, some economists question whether the stimulus can really make a difference. In this issue of Strategic Spotlight, we consider the recent effects of loose monetary policy and whether the Fed has "reached its limit."

Anemic Labor Market
In launching QE3, the Fed appears focused on stimulating the moribund labor market. Statements by Fed Chairman Ben Bernanke reflect grave concern about the long-term costs of elevated unemployment, which include chronic deterioration of skills among workers and declining labor force participation. We acknowledge that the Fed's QE programs have helped stabilize the economy—notably by lowering borrowing costs across all segments of the economy and stimulating spending through a "wealth effect" from improvements in housing and financial asset values. The housing market, in particular, has benefitted strongly from the lowering of mortgage rates and, after years of contraction, is finally on the rise. In addition, the liquidity injections have allowed banks to heal and gradually reduce risk on their balance sheets.


What About Inflation?
Additional easing, however, comes with risk of potentially higher inflation. Critics have observed that "printing money" will inevitably stoke inflation. Still, three years after the first round of QE was implemented (with the Fed's balance sheet expanding 300%), annual consumer price inflation hovers close to only 2%.


How is that possible? A primary reason is that, while the Fed's balance sheet has increased significantly, a broader measure of money, M2 (all amounts of money in checking and savings accounts, certificates of deposit, and money market accounts), hasn't been expanding quickly. Even as interest rates have declined, bank lending standards have tightened, particularly impacting individuals and small businesses. In other words, the money injected into the system by the Fed has not translated into credit creation as many financial institutions are more than happy to park excess cash in Treasuries. In economic parlance, the "velocity" of money (i.e., the rate at which money is transacted) has dropped. Until the process of credit creation is rekindled, inflation should remain in check.

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