Commentary

The Fed vs. the Recovery

One year ago, on Aug. 27, 2010, Federal Reserve Chairman Ben Bernanke explained the rationale for a second round of quantitative easing. “A first option for providing additional monetary accommodation is to expand the Federal Reserve’s holdings of longer-term securities,” he said, thereby supposedly “bringing down term premiums and lowering the costs of borrowing.”

Yet the bond market promptly reacted by raising long-term interest rates. The yield on 10-year Treasurys, which was 2.57% at the time of his Jackson Hole, Wyo., address, climbed to 3.68% by February 2011 and did not dip below 3% until late June when QE2 was coming to an end. The price of West Texas crude oil, which was $72.91 a year ago, remained above $100 from March to mid-June and did not come down until QE2 ended and the dollar stopped falling.

When Mr. Bernanke spoke, the price of a euro was less than $1.27. By the week ending June 10, 2011, 15 days before QE2 ended, the dollar was down about 15% (a euro cost $1.46). In that same week, The Economist commodity-price index was up 50.9% from a year earlier in dollars—but only 22.8% in euros. How could paying much more than Europe did for imported oil, industrial commodities, equipment and parts make U.S. industry more competitive?

In the end, quantitative easing turned out to be an anti-stimulus which stimulated nothing but the cost of living and the cost of production.”

The chart nearby subtracts the contribution of government purchases (such as hiring and construction) from real GDP growth to gauge the growth of the private economy. The generally negative contribution of government purchases (column two) does not mean government spending has slowed, as some contend. Instead it reflects the fact that federal and state spending has been increasingly dominated by transfer payments (such as Medicaid, food stamps and unemployment benefits) which do not contribute to GDP, and in some cases reduce GDP by discouraging work.

The chart also shows that growth of private GDP was also much faster before QE2 than it has been since, and the increase in producer prices (i.e., U.S. business costs) was much more moderate. And that is no coincidence.

Former Obama adviser Christina Romer, writing in the New York Times in late May, said that “a weaker dollar means that our goods are cheaper relative to foreign goods. That stimulates our exports and reduces our imports. Higher net exports raise domestic production and employment. Foreign goods are more expensive, but more Americans are working.”

Well, foreign goods certainly did become more expensive during the second round of quantitative easing, but it is doubtful that “more Americans are working” as a result. Industrial supplies and materials accounted for 34.5% of U.S. imported goods so far this year, according to the Census Bureau, and capital equipment and parts accounted for an additional 23%. As Fed policy pushed the dollar down, higher prices for imported inputs such as oil, metals and cotton meant higher costs (producer prices) for U.S. manufacturing and transportation.

In demand-side theorizing, monetary stimulus means the Fed buys more bonds. The Treasury has certainly been selling a lot of bonds, and the Fed has been buying (monetizing) a huge share of those bonds. That helped push the broad M2 money supply up at a 6.8% rate over the past six months. Yet the only thing we have to show for all that stimulus over the past year has been rapid inflation of producer prices and a simultaneous slowdown in the growth of the private economy. Consumer price inflation also accelerated to 5.2% in the first quarter and 4.1% in the second, from just 1.4% in the third quarter of 2010.

Imported goods did indeed become more expensive while the dollar was falling, rising at a 15.1% annual rate over the past three quarters according to the government’s report on GDP. But exported U.S. goods also became more expensive, rising at an 11.4% rate over that same period.

The fourth column in the chart shows that net exports were a subtraction from GDP in early 2010 when the private economy was growing most briskly, thus raising the demand for imported materials and components. The rise of dollar commodity costs and producer prices in the wake of QE2 reduced the growth of real imports because it reduced the growth of real GDP.

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Many journalists credit QE2 with raising asset prices, which was certainly true of precious metals but not of housing. It is also true that stock prices generally rose over the past year, but it is implausible to link that to quantitative easing.

Operating earnings per share for the Standard & Poor’s 500 companies rose to an estimated $24.86 by June 30, up from $20.40 a year earlier. Fed policy cannot possibly explain that rise in earnings because domestic output slowed and producer prices rose under QE2, while more than 46% of the sales of S&P 500 companies have come from foreign countries.

Berkeley economist Brad DeLong, writing in the Economist, suggests that, “Aggressive central banks can shift expected inflation upward and thus make households fear holding risky debt and equity less because they fear dollar devaluation more.” But individual investors often react to such fears by dumping equities and speculating in gold and silver. What good does that do?

In short, the Fed’s experiment with quantitative easing from November 2010 to June 2011 was accompanied by a falling dollar and inflated prices of critical industrial commodities, including oil. The net effect was to reduce the profitability of manufacturing and distributing products in the United States, and therefore to shift such activities (and jobs) to other countries which were less handicapped by the dollar’s weakness.

Every postwar recession but one (1960) has been preceded by a spike in oil prices of the sort we experienced when the dollar fell and oil prices doubled from August 2007 to July 2008 (reaching $142.52), and to a lesser extent when the dollar fell and oil prices rose to $112.30 at the end of April 2011 from $72.91 in late August 2010. Conversely, during the 1997-98 Asian currency devaluations (and soaring dollar), the U.S. experienced a booming domestic economy as the dollar price of oil dropped to $11 by the end of 1998.

Those who are now looking backwards at how poorly the U.S. economy performed under QE2 in order to “forecast” the future appear to be neglecting the potentially beneficial effects of a firmer dollar in deflating the bubble in U.S. commodity costs. In the end, quantitative easing turned out to be an anti-stimulus which stimulated nothing but the cost of living and the cost of production. Good riddance.

Alan Reynolds, a senior fellow at the Cato Institute, is author of Income and Wealth (Greenwood Press, 2006).