Did the Fed Really Save the Economy During the Financial Crisis?

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“When you break a leg, you don’t just snap the pieces back into place; you leave the cast on until the bone heals. Otherwise, you risk doing even greater damage. And in this case, the economy wasn’t ready to walk on its own,” said John Williams, president of the Federal Reserve Bank of San Francisco on Monday. Williams, currently a non-voting member of the Federal Open Market Committee, was defending the policy decisions taken by the Federal Reserve during and in the wake of the financial crisis, the most important of which were to keep the key federal funds rate near zero and reduce long-term interest rates through purchase of long-term assets.

Williams was responding to critics who argued that the Fed should have exited its accommodative or easy money policy around 2010 and let the economy recover on its own. Williams explained that doing so would have been a major mistake. His argument is that the unemployment rate at 9.5 percent in 2010 was still high and that deflationary pressures persisted even after the third round of quantitative easing started, under which the Fed purchased longer-term Treasury bonds and mortgage-backed securities to inject liquidity in the system.

Even after QE began, the unemployment rate hovered around 8 percent. In order to propel and support the economic recovery enough to reduce unemployment to the Fed’s desired rate of around 5.5 percent, the Fed had to do what it did, which was to stick with a loose monetary policy, according to Williams.

But every policy decision that the Fed makes comes with a cost. An important risk pointed out by the critics of such a policy has been the Fed’s ever-expanding balance sheet. The Fed’s balance sheet has grown to $4.3 trillion, an increase of about $3 trillion since December 2007, as the Fed bought assets under its large-scale asset purchase (LSAP) program to provide liquidity in the markets. Currently, the Fed continues to buy bonds on a monthly basis under the LSAP program, though the purchases are being reduced steadily each month. As it stands, the Fed is purchasing $15 billion worth of mortgage-backed securities and $20 billion worth of longer-term securities each month.

Williams assured critics that the Fed has enough weapons in its armory to reduce its balance sheet without really disrupting asset prices and causing inflationary risks.

“Importantly, we can now pay interest on reserves held at the Fed and we have other tools to reduce reserves even with a large balance sheet,” Williams said Monday. “This means that the usual process of the money multiplier — whereby ample bank reserves can fuel rapid growth in the money supply — is short-circuited. These tools mean we can control short-term interest rates as needed to stem any inflationary pressures down the road.”

The Fed has also been criticized for making space for fiscal lethargy by keeping the benchmark federal funds rate — the rate at which banks borrow from each other overnight — low for so long. When interest rates are low, it becomes easier for fiscal policymakers to fund the budget deficits by borrowing through public debt.

“This position argues that the Fed is somehow too reliable; that because we have the tools to manage a crisis, other institutions will avoid their own areas of responsibility because they can rely on us to pull an economic rabbit out of our hat,” Williams said. “If there’s no urgency, they can avoid action on politically volatile legislation, and the can gets kicked further and further down the road. Decisions about taxes, spending, and entitlement programs will always collectively be a political third rail, and monetary policy — be it accommodative or fully normalized — won’t change that.”

Something that both regulators and critics agree to is that the pace of economic recovery has been disappointingly slow in spite of keeping monetary policy as accommodative as possible. In 2013, consumer price inflation as measured by personal consumer expenditure grew only 1.1 percent the entire year, the lowest increase since 1960. The situation is only a little better now, with the PCE having risen to about 1.8 percent year on year, according to the latest data; that is still below the Federal Reserve’s inflation target of 2 percent.

Williams gave himself a pat on the back for a significant improvement in labor market conditions. The unemployment rate has inched down from 9.5 percent in 2010 to 6.3 percent in May this year. However, the quality of this improvement remains questionable.

For example, the reduction in the number of layoffs over a year has been hardly significant. The total number of layoffs fell from 1.7 million in April 2013 to 1.65 million in April 2014, the BLS monthly Employment Situation report showed. The labor force participation rate — which is the pool of people who are willing and able to work –declined from 63.4 percent in May 2013 to 62.8 percent in May 2014.

Looking at gross domestic product, economic growth has been highly unstable in spite of policy accommodation to the extent that GDP in the first quarter declined 2.9 percent, the steepest decline since 2007.

“Looking past the first-quarter drop, I expect real GDP growth to run above 3 percent for the remainder of the year,” Williams said. “That’s in no way blisteringly fast, but it is enough to keep the labor market moving in the right direction.”

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