The Fed Is Not Out of "Silver Bullets"

by Jeremy J. Siegel

The Fed’s move on August 10 to “keep the balance sheet of the central bank stable” and offset the run-off of mortgage-backed securities with Treasury purchases was just a baby step. Much stronger measures can and should be taken to combat the economic slowdown.

As readers of this column know, I am a strong supporter of Ben Bernanke, Chairman of the Federal Reserve Board. I think his bold measures to insure the liquidity of the banking and financial system saved us from repeating the misguided policy that led to the Great Depression of the 1930s. This is why I was disappointed in the Fed’s move on August 10 and Bernanke’s testimony July 21 before Congress, one of the Fed’s ritual semi-annual appearances that go back to the 1970s.

During his meetings before Congress, Bernanke responded to a question by Senator Bunning of Kentucky asking whether the Federal Reserve “was out of bullets” in its fight against the faltering economy. Bernanke responded, “I don’t think so.” Later he noted other measures the Fed might use to stimulate the economy, but only said “there is some probability they will be effective.”

Bernanke should not hedge. When you are the head of the world’s most powerful central bank, expressing doubt about the Fed’s effectiveness is a mistake. It is mandatory that the policymakers and central bankers display confidence in their policy tools. And the historical evidence is that Bernanke has every right to believe the Fed can still be very effective.

Quantitative Easing

In last month’s column I recommended that the Fed consider reducing the interest rate it pays on bank reserves to zero and engage in quantitative easing to help the economy emerge from the current soft patch. Quantitative easing, or QE as it is often called, occurs when the central bank expands the quantity of Federal Reserve credit by increasing the reserves in the banking system. QE is employed when the normal policy instrument of the Fed, the Federal Funds rate, is at or near zero.

In fact, Bernanke had already engaged in significant quantitative easing during the financial crisis in 2008 by supplying the banking system with over $1 trillion of reserves in excess of the banks’ statutory requirements. These reserves were far more than are required to bring the Fed Funds rate down to its current 0% to 0.25% level, a range that the Fed adopted in December 2008.

Some argue tha,t since banks already hold more reserves than required, additional reserves would not have any further effect on lending or economic activity. But that conclusion is not warranted. Banks hold large excess reserves because they wish to show regulators and investors a high level of liquidity.

This does not mean that banks would hold unlimited excess reserves. In fact, banks are not happy earning near zero interest on these reserves, nor are investors satisfied with similar rates on their money market funds. Placing more zero-interest reserves into the banking system will tempt more banks to make loans where the profit margin is much higher.

Although the Fed’s main policy tool, the Fed Funds rate, works on short-term interest rates, QE has the potential to lower longer-term rates, especially if the asset purchases are concentrated in long-dated securities.

In a recently published article, Taeyoung Doh, a research economist at the Federal Reserve Bank of Kansas City, gives evidence that asset purchases may be a much better instrument in lowering long-term rates than giving guidance in the FOMC directives, such as the “extended period” language which Wall Street watches so attentively in the statements following Fed meetings.

Japan’s Experiment

Those who object to quantitative easing point to Japan’s alleged failed experiment with QE from March 2001 to March 2006. During that period the Bank of Japan increased reserves markedly, yet that did little to improve Japan’s economic prospects.

But a close look at the Japanese data does not support this pessimism. Between 2001 and 2006, deflationary forces were arrested in Japan, the economy-wide price level remained constant, and annual GDP growth did increase by about 0.5% from the average of the previous decade. I admit QE did not lead to robust growth, but Japan’s slow growth over the last two decades is more related to structural problems in the Japanese economy and the rapid aging of the population, not to a bubble that burst more than 20 years ago. Furthermore, the effectiveness of the Bank of Japan’s QE policy was reduced by its implementation that began well over a decade after the markets collapsed in the 1990s. This lag allowed deflationary pressures to sink much deeper into their economy than now exists in the U.S.

One of the reasons the Bank of Japan finally abandoned QE was that the Japanese public was very uneasy about unlimited expansion of the money supply. Most Japanese still remember the post World War II inflation that devalued the purchasing power of Japanese yen by more than 100 to 1, and they feared that QE could bring about another inflationary episode.

The U.S. economy is far better suited to QE than Japan’s. Serious deflationary forces have yet to take hold, while inflationary expectations have been held well in check. Adding reserves will induce banks and investors to buy longer-dated and higher-yielding assets, reduce long-term rates, and spur more lending by the banks.


The Fed is far from out of silver bullets. Fed Chief Bernanke must be confident in the potency of all the Fed’s policy tools, not just the Fed Funds rate. Quantitative easing is a viable policy and, when combined with a reduction in the interest rates on reserves and the continued support of the asset-based securities markets, the Fed can deliver a potent combination of policies to stimulate the economy.


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