It is a subtle change in tone but nonetheless significant. The Federal Reserve, while continuing to hint at future quantitative easing (QE), seems at last to feel a need to address the longer-term inflationary risks of such policies. Accordingly, Fed Chairman Ben Bernanke unveiled a new approach to quantitative easing, what he calls "sterilized QE." He claims it would both support markets (and the economy) and at the same time guard against any longer-term inflationary consequences. Though there is good reason for skepticism about the technique he has outlined, this recent change in tone does offer encouragement.
Several recent developments could have prompted the Fed's seemingly sudden interest in longer-term inflationary issues. The recent report on rising labor costs could be one. According to the Labor Department, hourly output per worker slowed in the fourth quarter to less than a 1% annualized rate of advance even as compensation gains accelerated to about a 4% annual rate. The resulting 3%-plus rise in the labor cost of a unit of output may not in itself raise fundamental inflation fears, but it could be taken as an early harbinger nonetheless.
More fundamentally, the Fed has received the signals that it long ago indicated would trigger a reappraisal of its policy. As far back as late 2009, Bernanke indicated that the Fed would reconsider its extremely easy monetary stance when it saw a substantive improvement in the jobs market and an increase in bank lending. Both have occurred. Payrolls have picked up, growing on average close to 250,000 a month of late, a far from robust picture but much improved over a year ago. Meanwhile, bank lending to businesses has also picked up along the lines sought by the Fed. Commercial and industrial loans have grown at more than 12% annual rate during the last six to nine months.
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Whatever the proximate cause of the Fed's new tone, Bernanke's sterilized QE plan raises questions. According to his description, the Fed would create new liquidity to buy long bonds, mostly Treasury issues and mortgages, but then would sterilize any inflationary impact by borrowing the liquidity back short-term at low short-term rates with what are called reverse repurchase agreements. In one respect, this plan looks like a variation of the Fed's "Operation Twist," in which it sold short-term paper from its portfolio in order to buy long bonds. In other respects, this scheme looks a little like a shell game. In order to sterilize the funds over time, the Fed would have to renew the repurchase agreements or "repos" as they are called, continually. Any slacking by the Fed would allow liquidity in the system to rise immediately. More fundamentally still, the Fed, to keep short-term rates low for its repos, would have to provide ample liquidity to the money markets, raising the question of whether a net increase in liquidity would not otherwise take place anyway.
For all the seriousness of such questions, this recent subtle change in the Fed's tone offers encouragement of a different sort. It suggests that the underlying economic and financial conditions have improved enough to allow the Fed, for the first time in a while, to consider longer-term matters. Previously the Fed was so focused on emergency needs that such distant inflationary implications, though mentioned, were treated as little more than an academic exercise. With the economy on life support, so to speak, as it seemed to be in 2009, 2010 and the middle of 2011, the Fed might even have worried that any reference to distant concerns would make the public fear a loss of essential monetary support. That policy makers now are ready to discuss such matters, even if action waits for a future date, speaks to a conviction that perhaps the worst of the emergency has passed.
The new tone should also reassure investors that the Fed is aware of these long-term dangers and, presumably, is ready to deal with them when and if the time comes. Those who have worried about the ultimate inflationary implications of all the monetary ease should find comfort in such an acknowledgement. Even if the sterilized QE technique seems inadequate, it implies that the Fed stands ready to take other steps should the need arise. The overall picture may not assuage all concerns. It seldom does. But, generally, the change in tone helps, whatever the questions about the chairman's latest novel policy scheme.
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