The Federal Reserve recently announced that it will increase or decrease the size of its monthly bond-buying program in response to changing economic conditions. This amounts to a policy of fine-tuning its quantitative-easing program, a puzzling strategy since the evidence suggests that the program has done little to raise economic growth while saddling the Fed with an enormous balance sheet.
Mr. Bernanke has emphasized that the use of unconventional monetary policy requires a cost-benefit analysis that compares the gains that quantitative easing can achieve with the risks of asset-price bubbles, future inflation, and the other potential effects of a rapidly growing Fed balance sheet. I think the risks are now clear and the benefits are doubtful. The time has come for the Fed to recognize that it cannot stimulate growth and that a stronger recovery must depend on fiscal actions and tax reform by the White House and Congress.
As we’ve argued in these pages before, the key to distinguishing between loose and tight monetary policy is what’s happening to nominal income: that is, to the size of the economy measured in dollar terms, with no adjustment for inflation. If the growth of nominal income is accelerating, then monetary policy is loosening; and if growth decelerates, it’s tightening. The right policy aims for steady growth, which happens when the supply of money rises and falls with demand.
The claim that the Fed cannot be trusted to unwind its balance sheet — that it will let inflation go out of control — ignores its actual record over the last five years. Inflation has consistently come in below the Fed’s target and unemployment above it: The Fed has erred, that is, on the side of tightness. The last five years have seen a lower average inflation rate than any five-year stretch since the mid-1960s. Yet all of the political pressure on the Fed from Congress has been directed at getting it to tighten more.
The worriers are wrong. The Fed can and should unwind its balance sheet without hurting the economy — especially if, at long last, it adopts the right monetary policy at the same time.