In the wake of Federal Reserve Chairman Ben Bernanke's testimony this week, it became clear to everyone that the central bank is not yet prepared to leverage monetary policy to increase job growth. As predicted, Bernanke is waiting for things to get worse before taking more aggressive steps.One key policy tool waiting in the wings is "quantitative easing" -- buying assets like mortgage securities in an effort to lower interest rates below the "zero bound" of conventional monetary policy. The Fed did this on an enormous scale during the financial crisis of 2008, and many believe that doing so helped forestall a much more serious financial calamity. However, the move also exploded the Fed's balance sheet to unprecedented size, including $1.1 trillion in mortgage securities.
Now the challenge is unwinding those balance sheets. The Fed has been making good money collecting interest on the mortgages, but selling them is going to be difficult, since the Fed could create a fire-sale atmosphere that will devalue not only their assets but mortgage securities in general. Some Fed observers worry that holding the assets could make it more difficult for the Fed to raise interest rates and control inflation, but since the last thing we need to worry about right now is inflation (we're at the lowest level in 44 years!) this objection rings hollow.
It's not foolish to be worried about unwinding the Fed's incredibly huge commitments to support the economy. But what unwinding we've seen thus far has been relatively painless, and while the long-term risk of inflation is certainly a concern, the vague nature of this worry doesn't outweigh quantifiable problems of unemployment and the costs of unused economic capacity that we face today. When the Fed chooses not to act now to buttress the economy, it's not because they don't know what to do. It's because they fear that, sometime down the road, they'll have to raise interest rates, and they worry that they won't be able to. It's not a very compelling rationale, and it speaks to how the Fed traditionally favors inflation control over it's other mission, maximum employment. That bias will undermine the Fed's independence more than any political criticism -- or audit -- ever will.
-- Tim Fernholz
