When assessing Federal Reserve Chairman’s Ben Bernanke’s performance, he deserves great credit for his role in preventing a depression.  While controversial, Bernanke’s aggressive moves to provide liquidity to an ailing US and global banking system helped avert an even bigger disaster.  However, there are significant risks in carrying the same policy for multiple years, as expressed by noted monetarist, Dr. John Taylor.  Dr. Taylor’s editorial from the Hoover Foundation highlights what those risks are.

Taylor asserts that Bernanke’s monetary policy has not delivered as planned.  When it was started in 2010, Bernanke expected that it would result in economic growth of 4% in 2012.  Actually, we achieved only half of that.  Even though one must say that the collapsing European economy and over-leveraged consumer balance sheets played a role in the disappointing recovery, Taylor makes a good point that it creates uncertainty.

This uncertainty arises from global investors worried about future inflation.  Even though inflation is low now, the Federal Reserve will have to eventually unwind their efforts and that could lead to rising interest rates.  This concern makes industry reluctant to plan for large investments that bring job creation.

The combination of leaving the Fed Funds Rate at zero and participating in large scale asset purchases do result in unintended consequences.  However before explaining those consequences, let’s learn about the role that the Federal Reserve in managing money supply.

Their primary tool in managing money supply involves buying and selling U.S. Treasury bonds.  These bond transactions impact the Fed Funds Rate, which is the interest rate charged by the Federal Reserve to other banks.  This is an important interest rate because all other forms of credit is based on it.  Interest rates on autos, homes, and credit cards rise and fall based on movements of the Fed Funds Rate.

When the Federal Reserve buys bonds, then that drives the Fed Funds Rate down and banks have more reserves that they can loan out to households and businesses.  If the Federal Reserve is concerned about inflation, then they sell bonds, which takes reserves out of the banking system.  While that will decrease lending activity, it will also slow the rate of inflation as money is taken out of the economy.

Interest rates are currently very low for consumers because the Federal Reserve has been extremely aggressive in buying U.S. Treasury bonds.  In fact, they have driven the Fed Funds rate down to essentially zero.  While borrowers will certainly appreciate that, savers will not.

Since savers are punished, that can lead retirees and pension funds to take on more risks in search of higher yields.  Making the wrong moves can easily lead to loss of wealth and would make seniors vulnerable at a time where their income-earning potential is limited.

It also gives banks an incentive to refinance low-performing loans out further into the future.  While the over-burdened borrower certainly appreciates more time to pay off a bad loan, this is not good news for banks and their shareholders, whose bottom-line will be reduced as the risk of non-performance remains, but the rate of return on those poor performance assets are reduced.

Another problem with monetary easing is that it encourages deficit spending.  With interest rates near historic lows, it becomes enticing for Congress to push aside tough decisions on taxes and entitlement spending and just continue running astronomically high deficits.  This is analogous to Chris Credit, who already has run up $20,000 on his credit card to make ends meet.  Then he receives a mailing offering him an extension on his credit limit to $50,000, in addition to a low, teaser annual percentage rate (APR) of 0%.  Therefore, he is more likely to run up his credit card bill than if he received an offer stating that his APR would rise to 20%.

While everyone can see the problem with Chris Credit, there are not enough people, who realize that the U.S. government is in a similar situation.  Even if the Federal Reserve can keep interest rates down for 2, 4, even 6 years down the road.  There will come a time when they must reverse their large scale asset purchases and that could sent interest rates skyrocketing to levels unseen since the 1970s.  High interest rates compromise living standards, as it becomes harder for business to finance job creation and households to afford homes that build up wealth.

If it appears obvious what the right solution is, why is Bernanke so stubborn?  That is because he is rightly concerned that changing monetary policy can easily lead us to deflation.  If the Fed Funds Rate rises as they sell off their bonds, then interest rates will undoubtedly rise.  The economic recovery is weak as it is.  Imagine consumers and businesses having to pay higher interest rates.  That could curtail consumer spending and force businesses to lower prices further in order to rid themselves of inventory and stock.  If this is done on a huge scale, then our overall price level would drop and that is just as bad, if not worse, than rising inflation.

As painful as this course of action would be, the Federal Reserve must start reversing their aggressive monetary policy at a prudent pace.  By keeping interest rates artificially low, it makes it harder to justify deficit reduction because the payoff in terms of lower interest rates are not there.  When politicians see interest rates rise due to unsustainable debt, that might drive legislators back to the table in order to achieve real deficit reduction.

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