Tags: Feldstein | Fed | Tools | Power

Harvard’s Feldstein: Fed’s Tools Are Quickly Losing Their Power

Friday, 29 June 2012 08:15 AM

A Federal Reserve decision to extend a program that lengthens the duration of its Treasury holdings to simulate the economy is not the right medicine the country needs, says Martin Feldstein, a Harvard economist and head of the Council of Economic Advisers under President Ronald Reagan.

Concerned with the tepid pace of recovery, the Federal Reserve recently expanded a $400 billion program that shuffles its Treasury holdings, known as Operation Twist, by another $267 billion.

Under Operation Twist, the Fed purchases longer-duration Treasury securities in the market while selling an equal amount of shorter-duration Treasury securities with the aim of keeping long-term interest rates low.

Editor's Note: You Owe It to Yourself to Know What Obama and Bernanke Are Hiding From Americans

On top of Operation Twist, the Fed has rolled out other monetary stimulus measures since the downturn, including rate cuts and outright asset purchases from banks.

But what the economy really needs is tax reform, which only Congress and the White House can push through, Feldstein argues.

"The United States Federal Reserve’s recent announcement that it will extend its 'Operation Twist' by buying an additional $267 billion of long-term Treasury bonds over the next six months — to reach a total of $667 billion this year — had virtually no impact on either interest rates or equity prices. The market’s lack of response was an important indicator that monetary easing is no longer a useful tool for increasing economic activity," Feldstein writes in a Project Syndicate column.

Tax reform, not monetary policy, is needed instead, though fiscal measures are more politically challenging to push through as opposed to monetary policy measures, which can be voted through in closed-door Federal Reserve meetings, the minutes of which are released long afterward.

Taxes and spending policies will take center stage at the end of this year, when Bush-era tax cuts and other tax holidays expire and automatic spending cuts kick in, a combination known as a fiscal cliff that could siphon billions out of the economy and derail recovery in 2013.

"What needs to be done is already clear. The cloud of a sharp rise in personal and corporate income-tax rates, now scheduled to occur automatically at the start of 2013, must be removed," Feldstein says.

"The projected increase in the long-term fiscal deficit must be reversed by stemming the growth in transfers to middle-class retirees. Fundamental tax reform must strengthen incentives, reduce distorting 'tax expenditures,' and raise revenue," Feldstein says.

"If these things happen in 2013, the U.S. economy can return to a more normal path of economic expansion and rising employment. At that point, the Fed can focus on its fundamental mandate of preventing a rise in the rate of inflation. Until then, it is powerless."

Other experts agree that Federal Reserve tools suffer from diminishing returns, especially bond buybacks from banks, known as quantitative easing.

The Federal Reserve has rolled out two rounds of quantitative easing since the downturn, known widely as QE1 and QE2, snapping up $1.7 trillion in mortgage securities held by banks and another $600 billion in Treasury instruments with the aim of steering the country away from deflationary decline while creating conditions ripe for investment and hiring.

Bank of America Merrill Lynch economists expect a third round to roll out in September, likely involving $500 billion in purchases of more mortgage-backed securities held by banks.

This time around, the tool, seen as much stronger than Operation Twist, is not designed to spur more robust recovery as it is to install a floor to prevent the economy from stalling out and contracting.

"Unfortunately, as the Fed has admitted, every additional round of QE has diminishing returns, especially in terms of feeding into the overall economy. We don't think it will play a very big role the job numbers or GDP," says Michelle Meyer, senior U.S. economist at Bank of American Merrill Lynch.

"We think if they were not to do QE, the economy would look weaker," Meyer told Moneynews.

"The challenge that the Fed has is when the economy slows sufficiently, when the stock market sells off, when the inflation break-even falls, if the Fed does not come forward with the accommodation that they expect, then you see a further weakening in the economy. So the fact that we think that the Fed will satisfy basically what the market expects, and what the economy needs, we won't see a significant change to unemployment."

Editor's Note: You Owe It to Yourself to Know What Obama and Bernanke Are Hiding From Americans

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