Shock and Awe from the Fed: Will it work?

You’ve seen the images, either on the hospital dramas on TV, or if you’re unfortunate enough, perhaps, in person.

The victim is having a heart attack, and the doctors gather around with the defibrillator. They press the paddles against the patient’s chest and… CLEAR!!  (BAM!!) – they shock the chest with charges of electricity to try to get the heart pumping again. If it doesn’t work at first, there’s a second attempt. CLEAR! BAM! And so on. As time goes by, additional attempts often become more desperate.

Metaphorically,  this is what the US Federal Reserve (America’s central bank) has been attempting with its so-called “quantitative easing”—shock the U.S. labour force back to life by pumping billions of dollars into the economy. They’ve already engaged in two paddle hits to the economy’s chest back in 2009 and 2010. On September 13,  they announced a third.

---

This time, the technique is a bit different. Rather than a single, powerful hit to the chest (the “BAM!!” as before), the Federal Reserve is,  in effect,  holding the paddles in place on the chest and sending smaller pulses of electricity into the body for a longer period of time. Yesterday, the Fed announced another round of asset purchases, this time mortgaged-back securities from banks. Instead of one massive purchase of several hundreds of billions of dollars, the Fed will purchase $40 billion each month repeatedly until it feels it doesn’t have to any more.

They also announced that interest rates—as influenced in that country by the Fed funds rate—will stay in place at near zero until mid-2015. Previously they had suggested mid-2014.

So,  will any of this work? Will holding the defibrillator steady on the patient’s chest help? Or will this just be yet another failed attempt by an increasingly desperate Federal Reserve?

is difficult to say. For one thing, the jury is undecided if, in fact, the first two attempts of quantitative easing were effective or not. True, they did not succeed in putting the U.S. economy back onto a normal course of growth of around 3-4 per cent real GDP expansion. But, then again, the U.S. has not slumped back into recession, nor has the dreaded Great Depression returned as some feared. It is impossible to go back and repeat the exercise of 2008-09 without the benefit of quantitative easing to see if it worked. Economists will be debating this for years to come.

What we do know is that the third round of quantitative easing yesterday cheered the markets. Equity prices around the world rallied, including here in Canada where the TSX was up by more than 127 points. Early trading Friday morning suggests even stronger enthusiasm for what the Fed did. Commodities such as oil have soared.

In the longer term, however, uneasy questions still loom. Can all of this quantitative easing—which is essentially creating money—have an effect without causing runaway inflation? Classic economic theory would suggest that printing money will undoubtedly lead to price increases. More dollar bills are chasing the same number of goods and services, and voila, prices jump! Some economists fear inflation will eventually get out of control as it did in Germany in the 1920s or Zimbabwe in the 2000s

Those fears, however, may be a bit premature. For one thing, the threat of price deflation, both in the U.S. and globally, is presently a much larger threat. And once asset prices start to fall, it is worse than when they start to rise. Deflationary price spirals are lethal and can last for years, even decades. Just ask Japan. They’ve had some experience with it.

Secondly, the kind of cash being injected into the U.S. economy isn’t physical paper dollar bills. It is a misnomer to suggest that the Fed is “printing money” as commentators often say. That’s just shorthand for “creating more cash.”

But since the cash is really just electronic blips on bank computer screens—not physical dollars—the cash can be pulled out of the economy just as quickly as the Fed is pushing it into the economy. Once inflation flares up even a tiny amount, the Fed can just as easily reverse these actions and sell assets, effectively sucking cash out of the economy. It can also start to raise interest rates very quickly, which would slam the brakes on inflation.

All of this requires a huge amount of confidence in the ability of the Federal Reserve to get the timing right. If they don’t—or if this third round of quantitative easing doesn’t work—the patient may still be in a fight for his life.