Now comes the hard part. Fed Chairman Ben Bernanke’s announcement that if the conditions are right he will wean the U.S. economy off quantitative easing within a year has already caused consternation in the stock market. Pumping money into the system by buying back government bonds at the rate of $85 billion a month has lately done little good, which is a persuasive reason to wind it down. But getting from here to there without incident is not going to be easy. It was simpler for Howard Hughes to land his gargantuan super-plane, the Spruce Goose.
Flooding the economy with easy money was meant to encourage businesses to borrow and invest. Instead, banks and businesses have ended up hoarding cash, waiting for a recovery to start before they take the plunge. Or the surplus money has been parked in stocks, lifting the market to an unprecedented, unsustainable high. That is what happens when you have a one-trick economic policy, dickering with the money supply and little else. As Keynes liked to say, you can’t get fat by buying a bigger belt. But stopping the flow of cheap money and hinting at an eventual increase in interest rates has consequences and they may be uncomfortable.
The first to get the jitters is the stock market. Even before Bernanke’s announcement, his previous hint that QE would be “tapered” sent a shiver through Wall Street. Now that he is turning off the juice for good, there is general trepidation. The eventual rise in interest rates is making the real estate market nervous, too, which is troublesome as home purchases are driving the still fragile recovery. On the other hand, there is no better time to buy a home. Mortgages will never be as cheap again, unless there is another slump-inducing financial meltdown, so now is the time to buy, or to refinance while interest rates are on the floor. And as the Fed withdraws from the government bonds market, yields are going to soar.
To ensure a smooth landing, Bernanke must be careful to ease his foot off the gas without letting inflation rip. Sound money economists have been issuing jeremiads since QE started, warning of a boom in prices that never came. Though it may be heresy to say so (ever since Paul Volcker, Bernanke’s predecessor at the Fed, deliberately provoked a recession to purge hyper-inflation from the system), a little inflation can be useful. Flat or falling prices are a disincentive to businesses, which need prices to rise — a little, but not too much — to turn a decent profit.
Even the hint of higher interest rates drives the dollar ever higher. As long as the euro zone remains in trouble, money flows into dollars as international traders’ safe haven. This is likely to continue, as the austerity regime imposed by Germany on its Mediterranean neighbors will last a decade or more. But a further increase in the dollar price is not what hard-pressed American exporters need to ensure their products and services look good compared to our trading rivals, who benefit above all from cheaper labor costs. An even stronger dollar also makes imports cheaper, leading to a widening trade deficit, meaning America is not paying its way in the world.