Fed Embraces Quantitative Easing: Lessons from Japan and Implications for the Dollar

December 16, 2008

By unanimous vote the Fed reduced the Fed Funds target to a range of zero to 0.25% from a point target of 1.0%. Much more importantly, officials “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.” In the present context, “price stability” refers to avoiding deflation, not promoting disinflation. The statement specifically announces that Fed purchases of agency debt and mortgage-backed securities will be “expanded,” that consideration is being given to buying longer-dated Treasuries, and that other expansions of the Fed’s balance sheet are being explored to support economic growth and credit market functionality.

The missing ingredient is the lack of quantitative growth rates for the balance sheet, money aggregates, credit, or excess reserves. Otherwise, this policy shift is a mirror image of what was announced in October 1979 to reduce double-digit inflation. For five years until March 2006, the Bank of Japan engaged in quantitative easing, keeping overnight rates pinned at zero and progressively raising a target for excess reserves. Japanese consumer price inflation excluding energy and food was still somewhat negative when that policy reverted to targeting interest rates. Some critics argued then that the shift was made too soon, and sure enough, Japan is now headed back into deflation. But Japan’s experience underscores a danger. Nominal interest rates kept at zero or quasi-zero levels seem to change money market functionality in enduring ways and damage an economy’s tolerance for what used to pass for normal interest rate levels that lie well above zero in both nominal and inflation-adjusted terms. Bank of Japan officials repeatedly revealed long-range plans to lift interest rates but never found an opportunity to act out that intention, even though Japan’s economy experienced its longest postwar economic expansion with real GDP growth that averaged 2.1% per annum over 6-1/4 years.

The FOMC’s statement does not lay out an exit strategy from quantitative easing in terms of timing but does explicitly predict “exceptionally low levels of the federal funds rate for some time.” The three words for-some-time is Fedspeak and meant to be intentionally vague but of a nature that convinces markets that the span will be lengthy. The truth is that officials do not know how long this stage will last. Nor has policy entered a monolithic state. A similar expression “for the foreseeable future,” was first used by the FOMC in May 2003, more than a year before it raised interest rates. With a shift to supporting credit conditions through an expansion of the balance sheet — that is, more Fedspeak for creating money — the hallmark of future policy is that it will evolve organically. Whatever innovation seems to work will be kept. If something does not succeed, something else will be tried instead. Rules will be made up as the Fed goes along. In this sense, there is much less structure to quantitative easing than what surrounded quantitative tightening in 1979-82. Many experts, some previously on the FOMC, have said that Fed officials understand that an exit from quantitative easing has to be engineered aggressively. Here seeing is believing. It will be very hard to pursue a series of rate hikes ranging from 50 basis points to 100 basis points each.

Despite this obvious danger, I cannot help recall the currency implications of the policy shift in 1979 and wondering how applicable such are, but in reverse, to the dollar now. I was an economist with Chemical Banks Foreign Exchange Advisory Service in October 1979, working on a team responsible for framing a broad macroeconomic and currency forecast for both a 1-year and a 5-year time horizon. The economists led currency projection meetings, but everybody in the group had an opportunity to voice an opinion and vote on the forecast. One of our corporate consultants from our London office with plenty of experience as a sterling-watcher and mindful of what Margaret Thatcher was already introducing in Britain voiced the following view. Said he, and I paraphrase, “this is nothing but an exercise in punk monetarism with very strongly positive implications for the dollar. We should project 2.50 dollar/mark for next year.” That represented a 42% rise of the dollar from DEM 1.76 at the time and a complete reversal of all lost ground from DEM 2.40 when Jimmy Carter was elected president in November 1976.

Although October 1979 came three months before the dollar’s trough, 1980 was a mixed year for the currency because quantitative tightening was applied in fits and starts, interrupted for a while when the White House imposed credit controls. The dollar traded below DEM 1.80 again in September 1980 but began a sustained upturn in the autumn, crested at 2.57 in August 1981 and eventually rose above DEM 3.45 in February 1985. To be sure, tight monetary policy was complemented with loose fiscal policy, giving dollar demand additional upward thrust.  And quantitative easing now will be counter-acting an endogenous credit tightening within the market as bank reluctance to lend persists. In Japan’s case, quantitative easing promoted carry trading and an extensive period of yen softness, which is now getting reversed.

Without these qualifications, the implications for the dollar now are proportionately negative to whatever extent the Fed increases its balance sheet. There are other mitigating factors, too. Before this global recession is over, other central bankers will be adopting quantitative targets. Some already have begun doing so. But most likely, none will outdo the Fed’s raw stimulus. A softer dollar will support exports and limit deflation. The Fed is well aware of the risks of excessively eroding confidence in its currency by major reserve asset portfolio managers, and will make a mid-course correction if needed to avoid a dollar rout. But the dollar had a good year in 2008, is well above its lows, and so is not in danger of being abandoned at this point. The short- and long-term dollar implication at first sight appear to be adverse.

The text of the Fed’s historic statement today can be read by clicking here.

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