A new ship is sailing, and it may never return to port. Monetary policy in the United States has embarked on a course through uncharted waters.
The Federal Open Market Committee announced a new monetary policy that was widely anticipated by market participants and analysts. But it was what the Fed didn’t say that caught markets by surprise.
The third round of quantitative easing — QE III — is under way without a stated end date. Previously, when announcing a new quantitative easing program, the FOMC would indicate how long the process would go on.
There is no telling now.
In addition to keeping bank interest rates near zero into 2015, the Fed announced this month that the principal from previous bond purchases — QEs I and II — will be reinvested. The Fed added that it will start buying more mortgage-backed securities, around $40 billion every month.
With these new purchases the Federal Reserve is now spending about $85 billion each month above and beyond its traditional monetary policy tools. With this new plan, the committee is hoping that long-term interest rates, and particularly home-loan rates, stay low and that consumers start spending more.
The Federal Reserve was created in 1913 in response to earlier financial panics. It operates the monetary policy of the United States through the FOMC. Monetary policy is any action undertaken by the U.S. central bank to influence the availability and cost of money and credit.
Historically, the FOMC used only three tools of monetary policy — open-market operations, the discount rate, and reserve requirements. The near-zero interest rates you see in your savings account are the result of both open-market operations and the discount rate — interest rates that influence what banks earn on their own money.
With three episodes of quantitative easing, the FOMC has gone well beyond its previous short list of tools. The central bank is operating in more sectors of the economy than just our banking system.
However, the open-ended nature of the newest program is exacerbating what economists call the time-inconsistency problem of monetary policy.
Historically, there has been a discrepancy between what policymakers say and what they actually end up doing. That is, policy is time-inconsistent and therefore not credible.
The lack of a credible commitment has the effect of raising inflation expectations. The FOMC isn’t saying how long it plans to buy more mortgage securities, so there is no way of knowing how much will be bought. There is nothing to hold the Fed accountable for inflation.
The financial markets responded accordingly.
The key measure of inflation expectations in the financial market is called the yield spread. This spread is the difference between the interest rate currently earned on 2-year and 10-year U.S. Treasury notes. The higher the spread, the more investors want in return to compensate for expected inflation.
In just one day following the FOMC meeting, the yield spread grew 13 percent from 1.41 to 1.59 percent. All of this growth occurred on the long end, as the interest rate paid on the 10-year note rose from 1.66 to 1.84 percent. Further, the average interest rate on 30-year mortgages was unchanged.
The new policy had the effect of only increasing the expectation that inflation will be higher in the future. There was no immediate effect on borrowing costs or any other aspect of the real economy.
QE III is serving only to raise uncertainty in the market. There is no telling where this ship is headed or when it will return to port.
PETER CRABB: Professor of finance and economics at Northwest Nazarene University in Nampa. firstname.lastname@example.org.