NCPA - National Center for Policy Analysis

The Hidden Costs of Monetary Easing

September 14, 2012

The Federal Reserve has increased its base money to finance the purchase of massive amounts of U.S. Treasury and mortgage-backed securities. Normally, this would be a recipe for inflation. However, the Fed argues that since the banks are holding excess reserves rather than lending them out, the inflation rate will not go up. As the Fed considers a new round of monetary easing, proponents argue that inflation is nothing to worry about, but overlook the other costs associated with monetary easing, say Phil Gramm, former chairman of the Senate Banking Committee and a senior partner of U.S. Policy Metrics, and John Taylor, a professor of economics at Stanford University and a senior fellow at the Hoover Institution.

  • Since September 2008, the Fed has acquired $1.16 trillion in government securities.
  • In fiscal year 2011, the central bank bought 77 percent of all additional debt issued by the Treasury.
  • This has allowed the Fed to borrow a trillion dollars without raising the external debt of the Treasury.
  • But when the Fed must remove liquidity by selling bonds, the Treasury will have to pay interest on the debt to the public.
  • In turn, this will raise up interest rates and crowd out private-sector borrowers, which will negatively impact economic recovery.
  • Additionally, debt-service costs would add nearly $100 billion to the annual budget deficit.
  • Moreover, when the Fed sells its holdings of mortgage-backed securities to reduce the monetary base, mortgage rates will rise since they would be sold during a real recovery.
  • Furthermore, Operation Twist, which shortened the average maturity date of externally held debt, will require the Treasury to borrow more money when the economy recovers and interest rates rise. This would increase the deficit and interest costs.

Proponents of monetary easing argue that the Fed has tools to minimize the impact it would have on interest rates. But the Fed has already pledged to maintain low interest rates until 2014, which has a significant impact on the Fed's ability preserve price stability.

Source: Phil Gramm and John Taylor, "The Hidden Costs of Monetary Easing," Wall Street Journal, September 11, 2012.


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