The Fed’s Trying To Get the Party Started, So Why All the Criticism?

George L. Perry

Fed bashing has a long history. The Fed has a dual mandate of achieving both high employment and low inflation, and pursues those aims by raising short term interest rates when aggregate demand threatens to become excessive and lowering rates when aggregate demand needs a boost. But while the mandate is symmetric, the popularity of raising and lowering rates is not. Politicians and Wall Street pundits have often criticized the Fed when it tightened policy because higher interest rates were seen as bad for jobs, profits and the stock market, and disliked by borrowers. As Bill Martin, Fed chairman in the ‘50s and 60s, observed, the Fed is unpopular because its job is to take away the punch bowl just when the party is getting good.

So why are some politicians and financial observers criticizing the Fed today when it is just trying to get the party started? In the typical postwar business cycle, high interest rates brought on recessions and then low short term interest rates helped start expansions that restored high levels of employment. This time the recession was brought on by a financial crisis that made it deep and stubborn, and conventional monetary easing-reducing short term rates by buying short term Treasury securities-was not sufficient. Short term rates have been zero for an extended period, yet the expansion has been slower than everyone wanted.

To its great credit, the Fed has innovated its policy by buying sizable amounts of long term treasury securities and government backed mortgage securities in order to reduce long term borrowing costs more directly. And it has committed to continue this policy of quantitative easing until specific targets for the expansion are met. But precisely because these steps are unprecedented, the consequences are less predictable than they would be with conventional policies, and critics can speculate more freely.

Are today’s critics on to something? One of their complaints is that the great liquidity the policy has produced will lead to inflation. Someday, inflation could become an issue, but not soon. Along with the rest of the advanced economies, the U.S. problem today is how to boost aggregate demand to expand employment, not how to contain it to resist inflation. Wage costs—a key element of any sustained inflation—are rising so slowly that they are impeding the growth of consumption, a key element of demand growth in the economy. This situation will change only very gradually, giving the Fed plenty of time to respond if it needs to.

Other skeptics suggest the Fed will have trouble unwinding its positions in government and agency bonds in an orderly way. Bond prices may well fall sharply once market participants believe the Fed is starting to reverse course. And that could cause stock prices to drop, too. But markets often adjust abruptly, and these changes would be consistent with the Fed’s changed policy aims. If market movements achieve the desired change in rates without much selling by the Fed, the Fed is under no compulsion to continue selling.

Finally, some critics believe the Fed’s easy monetary policy-both quantitative easing and ultra low short term borrowing rates-is creating bubbles in stocks and possibly other assets. Stocks have had a long rise since the market bottom in 2009, and a sharp rise over just the past several weeks. But profits have risen sharply over the long period and price to earnings ratios are generally near the middle of their historical range, not the top.

A correction in stocks can happen with no apparent reason and the Fed’s aggressive easing will not be responsible when the next one comes. The present easing will benefit the stock market in the longer run by continuing to promote economic expansion. Just compare stocks in Europe, where economic expansions have faltered, with stocks in the U.S.