The latest minutes from the Federal Reserve meeting of September 12–13 had some interesting insights that were not initially obvious. Before we get to that, I do want to make one thing clear. I believe that each member of the Federal Reserve, when deliberating monetary policy action, does have the best interest of the country at heart. Where many differ is on the effectiveness and rationale of said monetary policy moves. As I stated in an earlier article, I believe the latest monetary policy action is only marginally beneficial, with large associated costs down the road.
While the latest monetary policy initiative by the Federal Reserve to buy $40.0 billion per month of mortgage-backed securities was agreed on by all members except one, the minutes of the meeting show far more concern among members to the effectiveness of this action. Believing that there was initially only one dissenter, I was under the impression that the Federal Reserve was essentially unanimous. With these minutes, it is clear that many more Federal Reserve constituents were also concerned.
Following the meeting, the Federal Reserve chairman Ben Bernanke did reiterate his belief that monetary policy cannot solve all of America’s problems. I do give him credit for raising these concerns, and it appears that he was not alone. In the minutes, the statement reads that several Federal Reserve members also were concerned about the effectiveness of the monetary policy initiative, seeing that a large part of constraints in the economy are structural.
Essentially, in my opinion, this boils down to the Federal Reserve firing their last bullets and voicing concerns that they hope Congress can hear. It is now up to the politicians to take the helm and do their part. During the financial crisis, the Federal Reserve did prevent a further collapse of the American economic system. I also believe that politicians have seen the power of monetary policy and feel they don’t have to make the difficult decisions and face voters with the consequences. This has to end.
Monetary policy has limits, we all know that. During an extreme financial crisis, especially if it stems from liquidity constraints, additional monetary policy liquidity is extremely beneficial. However, when structural issues are the culprits that are constraining an economy, monetary policy is severely limited and potentially negative in the long term, as there are significant unintended consequences as a result.
The clearest example of this bottleneck is the velocity of money. The velocity of money is simply the frequency of money—the level of activity. When velocity is high, more transactions are occurring and more economic activity is taking place. If we take a look at M2, which is a broad definition of money to determine the amount in circulation, it’s currently at lows not seen since the 1960s. (For anyone interested in seeing the data themselves, they’re available on the Federal Reserve Bank of St. Louis web site.)
In fact, it’s quite obvious that it’s highly correlated with gross domestic product (GDP)—it would have to be. An economy can’t be growing if there are less transactions occurring. This also means that you can’t push on a string—there are trillions of dollars available, yet fewer transactions. The Federal Reserve can’t force people or companies to be active; this is where fiscal policies come into play.
It’s obvious that the effects of monetary policy are becoming quickly exhausted. The Federal Reserve has done everything it can and then some; the time is now for Congress to act. Almost every corporate report I read, the business leaders state their concern and uncertainty about future regulation and policy with respect to the “fiscal cliff” and the upcoming elections. Businesses cannot function with political uncertainty. I believe that Congress will reach a deal to avert the fiscal cliff, and this will tremendously help the economic situation next year. I just hope the actions by the Federal Reserve are able to be undone without paying too high a price.