Monetarist economists have been apoplectic for some time about the policies of Ben Bernanke, the Chair of the US Federal Reserve. Staunch monetarists have been warning that his policies threaten to unleash massive inflationary pressures. They point to the dramatic growth of the Federal Reserve’s balance sheet and the commensurate growth in high-powered money as precursors of a historic inflation bubble. They point to commodity prices and their effects on wholesale prices as indicators that a new round of inflation is just around the corner.
To stem the inevitable inflation bubble, these economists have been arguing in favor of higher interest rates and a reversal of the Fed’s policy. That is, they want the Fed to start draining reserves and hence liquidity out of the banking system.
While Bernanke does not intend a replay of his quantitative easing round 2 policy, he is committed to keeping interest rates at their historic lows since inflationary pressures do not appear on the horizon and the US economy continues to be weak. Higher interest rates will only make the recovery more problematic and prevent the unemployment rate from declining.
As I have said before, fortunately Bernanke was at the controls in 2008 rather than any one of his monetarist critics.
Steve Hanke, an economics professor at John Hopkins University, has come up with a new twist to support higher interest rates. I guess if one set of facts does not support your case; namely that inflation rates are about to accelerate, then, as a good economist, you look for another set of “facts”.
In a column in today’s Financial Post, Hanke argues that low interest rates have produced a credit crunch and thus are curtailing the economic recovery. He does admit that his argument is counterintuitive, Indeed it is, but it is also downright silly.
He states: “[H]ow can banks make money without making wholesale and/or retail loans? Well, it’s easy and “risk free” to boot. By holding the federal funds rate near zero, the Fed creates an opportunity for banks to borrow funds at virtually no cost and use them to purchase two-year U.S. treasury notes, which yield about 40 basis points…a bank can do quite well playing the treasury yield curve.”
Some minor details are conveniently overlooked by Hanke. This so-called opportunity to capitalize on the yield curve has often been available, even when short-term rates were well above 0%. Whenever the yield curve has been upward sloping (which is most of the time), the opportunity has existed. But banks have not taken advantage of this opportunity in the past.
Moreover, the opportunity is not risk-free since rates on tw0-year treasuries can increase thus generating capital losses for the banks. There is always a risk.
Hanke overlooks as well the weak housing market that continues to play havoc with the mortgage market. He also overlooks the fact that large companies are sitting on over $1 trillion in cash because of the global economic uncertainties. Consequently, they are reluctant to commit to any major investments or significant new hirings. These same uncertainties have made the banks hesitant to open up the loan spigots. Until the economic recovery is perceived to be on a strong and sustainable foundation, banks will continue to hesitate lending.
It is not the zero interest rate policy of Bernanke and the Fed that is inhibiting lending by the banks. The lack of confidence in the economic recovery is the culprit.
The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.