Between a Rock and a Hard Place, or Up Against the Wall?

A friend who teaches in the social sciences–but not economics–wrote:

“Did you read this Marty Feldstein piece in the WSJ yesterday? I know bupkes about Fed policy, but it seems to me the Fed is between a rock and a hard place. It continues to buy U.S. securities (in part, by printing money) to keep the economy afloat. But Feldstein suggests this is all going to come crashing down. Do you agree? Who should I turn to for an alternative perspective?”

Feldstein warns that both quantitative easing and a softer line on inflation by the Fed are likely to “confuse the general public and undermine confidence in the bank’s commitment to price stability.” In particular — and I think this what alarmed my friend — was Feldstein’s concern that:

“Because of the Fed’s purchases of bonds and mortgage-backed securities, commercial banks have $1.4 trillion more in reserves than is legally required by the size of their balance sheets. The banks can use these excess reserves to create loans and deposits, which will increase the money supply and fuel inflation…[T]he day will come when aggregate demand is increasing, companies want to borrow, and the banks are willing to lend aggressively….The final problem with the Fed’s unconventional policy is perhaps the most obvious. By keeping long-term interest rates low, it removes pressure on Congress and the Obama administration to deal with budget deficits…The Fed, in short, has killed the bond vigilantes before they could have forced Congress to act.”

So from Feldstein’s perspective the Fed is interfering with healthy price signals from the bond market to both private agents and the Federal government. The “bond market vigilantes” schtick is a retort to Paul Krugman and Brad DeLong.

Official U.S. unemployment is 7.8 percent and the employment-to-population ratio is around 6 percentage points below its 2000 peak — lower than it’s been anytime since 1984. I just went to a session at the American Economics Association meetings in San Diego where Jesse Rothstein argued persuasively that the issue is strictly aggregate demand (not a growing taste for vacations). There is a lot of slack in this economy.

The Federal Reserve isn’t between a rock and a hard place: it’s up against a wall because it can’t lower interest rates below zero. (In principle, the Fed could tax reserves which would effectively offer banks a negative interest rate for leaving money at the Fed rather than lending it out.)

Feldstein’s worry that the banks are poised for a wild lending binge seems far-fetched in the current climate. And if the banks were headed out for a binge, it’s clear from the last two major bubbles that regulation, not interest rates, can stop the party. (Who cares if you are paying 5.5 percent or 6.6 percent if you “know” that your house will appreciate between 25 and 30 percent per year?)

As for creative uses for 1.4 trillion in reserves, blog contrtibutors Heidi Garrett-Peltier, James Heintz, Robert Pollin, and Jeannette Wicks-Lim have a great take on what could be possible if some of the funds that banks are hoarding got pushed out into loans for infrastructure and green investment.