Fed Chairman Ben Bernanke is likely to sway the consensus of governors to allow more easing next week. Too bad the Fed and monetary policy have already run their course.
As the Chairman himself said at Jackson Hole, Wyo., the U.S. economic mess is a fiscal policy issue. Fed
Governor Charles Plosser echoed the chairman's sentiments last week, saying he was doubtful monetary policy could do more. The reason lies in the quantity theory of economics called the velocity of money which explains the rate of multiplication of money, or how often a dollar actually changes hands in the financial system.
In simple terms, imagine a farmer spends $100 on a new piece of farm equipment. The equipment manufacturer buys $75 worth of parts from a supplier to retool and then pays $25 in salaries to its employees to make the parts. The $100 initial expenditure changed hands a sufficient amount of times to create $200 of spending in the economy. In effect the velocity of money is two.
This concept is at the heart of the Fed's conundrum: the velocity of money tends to decline when the economy struggles. The central bank can attempt to stimulate the economy by adding money to the system, but much of it sits idle, with corporates hoarding cash, banks unwilling to lend and consumers de-leveraging. As Nobel Prize-winning economist Paul Samuelson said: "You can force money on the system but you can't make the money circulate against new goods and new jobs."
For the Fed that is a huge problem. The Fed could add more and more stimulus but if confidence continues to decline and velocity were to fall further, it would weaken the impact of that stimulus. That was the argument of those opposed to QE2.
That is not to say the Fed will not try. They will likely buy more paper on the long end and perhaps expand to securities of lesser collateral, but that will only flatten the yield curve not stimulate spending. If they do an "Operation Twist" that will push yields up in the short end, add to the dollar liquidity squeeze facing European banks at the moment and push the dollar higher.
In the end the weight of the problem falls on Congress and the president, who control government spending. The European Central Bank will soon be compelled to add liquidity and lower rates. The result, lower global interest rate differentials with the U.S., a stronger dollar and a not so effective Federal Reserve.
As the Chairman himself said at Jackson Hole, Wyo., the U.S. economic mess is a fiscal policy issue. Fed
Governor Charles Plosser echoed the chairman's sentiments last week, saying he was doubtful monetary policy could do more. The reason lies in the quantity theory of economics called the velocity of money which explains the rate of multiplication of money, or how often a dollar actually changes hands in the financial system.
In simple terms, imagine a farmer spends $100 on a new piece of farm equipment. The equipment manufacturer buys $75 worth of parts from a supplier to retool and then pays $25 in salaries to its employees to make the parts. The $100 initial expenditure changed hands a sufficient amount of times to create $200 of spending in the economy. In effect the velocity of money is two.
This concept is at the heart of the Fed's conundrum: the velocity of money tends to decline when the economy struggles. The central bank can attempt to stimulate the economy by adding money to the system, but much of it sits idle, with corporates hoarding cash, banks unwilling to lend and consumers de-leveraging. As Nobel Prize-winning economist Paul Samuelson said: "You can force money on the system but you can't make the money circulate against new goods and new jobs."
For the Fed that is a huge problem. The Fed could add more and more stimulus but if confidence continues to decline and velocity were to fall further, it would weaken the impact of that stimulus. That was the argument of those opposed to QE2.
That is not to say the Fed will not try. They will likely buy more paper on the long end and perhaps expand to securities of lesser collateral, but that will only flatten the yield curve not stimulate spending. If they do an "Operation Twist" that will push yields up in the short end, add to the dollar liquidity squeeze facing European banks at the moment and push the dollar higher.
In the end the weight of the problem falls on Congress and the president, who control government spending. The European Central Bank will soon be compelled to add liquidity and lower rates. The result, lower global interest rate differentials with the U.S., a stronger dollar and a not so effective Federal Reserve.
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