In effect, the Fed has been monetizing the paper assets held by commercial banks. This action has rapidly increased the U.S. money supply, though conventional definitions of the money supply have little meaning at this time.
But will this new monetary policy approach work? It certainly was tried in Japan. The Bank of Japan lowered its policy rate to zero in February, 2001, and introduced quantitative easing in the following month. Quantitative easing and the zero interest rate policy both ended in Japan in 2006.
While we are working with an almost new economic paradigm, here are some of our concluding expectations.
- Despite all of the goodwill around, the new U.S. administration has inherited a wrenching economic problem that could haunt President Barack Obama's entire first term of office.
- Quantitative easing, together with the substantial fiscal policy stimulants, and in combination with other financial supports will likely work for the major economies, although it will take time.
- There is considerable financial stimulus associated with zero interest rates, and of course, financial markets should ultimately reflect some positive gains. Already there are some signs that the financial markets are unclogging a bit.
- The overall solution requires much more than monetary stimulus, including major fiscal stimulants, some financial bailouts, as well as some new structural initiatives to unclog the banking and credit markets.
- In the meantime, zero or close to zero central bank interest rates imply considerable currency volatility. The U.S. dollar has recently been sliding against the yen and the euro, and the Canadian dollar has been trading very close to 80 cents, but also with considerable volatility.
- The recent sharp slide in the U.S. dollar together with the huge increase in the U.S. monetary base foreshadow the longer-term inflationary risks that the Federal Reserve is taking through jump-starting the U.S. economy using aggressive monetary stimulation.
The expectations of the new Obama team, in terms of economic policy, are exceedingly high. To paraphrase Winston Churchill: "Never was so much expected by so many of so few." Will the combination of a zero interest rate policy, quantitative monetary easing, and a huge package of fiscal stimulus be enough? Only time will tell; but the global economy needs this recovery package to be a success.
Arthur Donner is a Toronto-based economic consultant. Doug Peters is the former chief economist of the Toronto-Dominion Bank.
