When Ben Bernanke was chairman of the Federal Reserve, he was fond of saying "monetary policy is not a panacea." Yet when one looks at actual policy since the 2008 financial crisis, it is difficult not to think that people, especially market players, have come to believe that the Fed is a cure-all for economic malaise.
Indeed, the Fed has changed thinking on the use of unconventional monetary policy to stimulate economic growth. The use of quantitative easing (i.e., large-scale asset purchases, including mortgage-backed securities) and financial repression (i.e., holding benchmark rates near zero and allowing real rates to go negative) are now part of conventional wisdom of central banks trying to boost global growth.
The Fed has increased its balance sheet from less than $800 billion before the crisis to more than $4.5 trillion, and has dramatically increased the monetary base in the process. Member banks are now holding nearly $3 trillion of excess reserves at the Fed due, in part, to payment of interest on those reserves since October 2008, and also because of regulations and policy uncertainty.
Those funds are not being lent out, and thus not entering the income stream. Thus, even though the Fed has been creating massive amounts of new base money, the growth rates of the monetary aggregates have not been inflationary. That situation, of course, could change as the economy heats up and confidence returns.
It is a myth to think that monetary authorities by a stroke of a keyboard can create economic prosperity or that monetary policy can be fine-tuned with every twist and turn of the real economy. Fed policy seems largely designed to prop up financial asset prices and to encourage risk-taking with the hope that newly acquired financial wealth will stimulate spending and ignite real economic growth rather than inflation.
Yet a long look at monetary history tells us that central banks cannot control real variables (e.g., employment, output, and real interest rates), except for short periods. When expectations are taken into account, and lags recognized, it becomes clear that "monetary stimulus" is not a substitute for the hard choices that need to be made to generate lasting economic growth.
Institutional changes that widen the scope of markets (private exchange) and limit the power of government to the protection of persons and property are the key to prosperity. Economic and personal freedom and responsibility under a genuine rule of law — not a powerful central bank that manipulates interest rates, politicizes the allocation of capital, and lacks any monetary rule to guide policy — are the fundamental conditions for expanding the range of choices open to individuals, which is the true measure of development.
When the Fed or other major central banks suppress interest rates, holding them below their natural market equilibrium levels, they distort capital markets and lead to mal-investments. Unlike other prices, the interest rate is an indicator of people's preferences for present versus future consumption, and therefore reflects time preferences. Interest rates are also used to calculate asset prices, so when rates are distorted so are asset prices.
With artificially low interest rates, people have little incentive to save for the future; they would rather load up on cheap credit and consume today rather than save and invest in the future. Likewise, with low rates, government debt looks less burdensome — and there is an added inducement to expand the size and scope of government.
The Fed's ultra-low interest-rate policy has imposed large costs on conservative investors who have stayed on the sidelines as the stock markets have boomed. They have suffered permanent losses because of the Fed's failure to normalize monetary policy. Meanwhile, those who have taken on more risk have profited by Fed policy, but their smiles could turn to tears when asset prices adjust to higher rates and the bubbles burst.
Eventually rates must rise to their natural levels consistent with time preferences and the productivity of capital. The Fed cannot peg rates forever. When rates rise, asset prices will fall and the government will face mounting costs of financing its huge debt. Junk bond funds will go under and there will be tremendous political pressure to bail out financial institutions and others considered too big to fail.
Many Fed policymakers appear glued to the vision of a trade-off between inflation and unemployment, and to the idea that the Fed can create wealth by repressing interest rates "for a considerable time." By basing monetary policy on forecasts of the real economy, the Fed creates great uncertainty.
There is no perfect model of the U.S. or global economy; the future is unknown and unknowable. That is why monetary policy cannot be a panacea, and why a rules-based regime is superior to pure discretion.