When President Obama gave his recent address at Knox College, he lamented the dismal state of middle-income families, whose real incomes have been stagnant or falling. He promised new policies that would restore upward mobility and improve prospects for growth and employment. However, he ignored the negative effects of the Federal Reserve’s unconventional monetary policies.

The Fed’s decision to hold its target interest rate near zero until at least mid-2015, and to continue quantitative easing until inflation reaches 2.5 percent and unemployment falls to 6.5 percent, is meant to stimulate investment and consumption.

According to Fed Chairman Ben Bernanke, “Highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy.” In reality, the Fed’s ultra-low interest rate policy and QE have underpriced risk, distorted capital markets and had little impact on increasing economic growth and employment.

Bernanke’s “portfolio-balance approach” designed to boost asset prices and spending has worked for some, as seen by the rising stock market.

However, he has underestimated the negative effects, and President Obama has been silent. By holding the federal funds target rate at near zero since December 16, 2008, and suppressing yields on U.S. government securities, the Fed has helped finance the large fiscal deficits while engaging in financial repression — that is, holding nominal interest rates so low that real after-tax interest rates turn negative.

In so doing, the Fed has hurt middle-class families and retirees who have saved for the future. They get virtually nothing on their lifetime savings while the Fed induces people to buy riskier junk bonds, stocks and commodities.

Current U.S. fiscal and monetary policies are myopic.

People may also decide to consume more, save less and borrow more for cars, homes and other goods.

By purchasing mortgage-backed securities (MBS) and allocating credit to the politically favored housing sector, the Fed is engaging in credit policy.

Moreover, by paying interest on excess reserves, the Fed has sterilized most of the massive increase in the monetary base (currency held by the public plus bank reserves).

Meanwhile, low interest rates have made banks less willing to make loans, especially to small businesses.

In a normal economy, under conventional monetary policy, increases in base money would be lent out and lead to a multiple increase in the monetary aggregates, boasting nominal income.

That has not happened under Bernanke’s unconventional policies.

The Fed’s biggest mistake has been to downplay the adverse consequences of its zero interest rate policy and QE. Without Fed interference, real interest rates would be set by market forces, not by monetary manipulation. In particular, nominal rates would be good measures of real rates, provided people expected long-run price stability, as was the case during the classical gold standard.

By suppressing short- and long-term interest rates, the Fed has distorted nominal rates, decreased private saving and fostered malinvestment. The artificially low rates are motivating the U.S. government and citizens to focus on the present and consume the seed corn that would generate economic growth.

Consequently, future real incomes and consumption will be lower than under market-set interest rates.

There is no free lunch. Achieving a higher standard of living in the future requires forgoing current consumption, saving and making prudent investment decisions. Current U.S. fiscal and monetary policies are myopic.

By postponing painful adjustments in entitlements and interest rates, policymakers hope to stimulate aggregate demand, but that experiment has failed. As Stanford University economist Ronald McKinnon has noted, “By trying to stimulate aggregate demand and reduce unemployment, central banks have pushed interest rates down too much and inadvertently distorted the financial system in a way that constrains both short- and long-term business investment. The misnamed monetary stimuli are actually holding the economy back.”

The Fed is expected to buy 85 percent of Treasury debt this fiscal year and 100 percent next year. Monetization of the debt is bound to raise inflationary expectations as the economy improves.

Interest rates will then rise even before the Fed unveils its exit strategy.

At some point in the near future, the Fed-induced asset bubbles will burst, and the malinvestment that has taken place will be revealed. The adjustment will be painful, and even more so the longer the day of reckoning is put off.

President Obama, are you listening?


James A. Dorn
About The Author James A. Dorn
James A. Dorn is Vice President for Monetary Studies and Senior Fellow at the Cato Institute. His articles have appeared in The Wall Street Journal, Financial Times and South China Morning Post. He has testified before the U.S.-China Security Review Commission and the Congressional-Executive Commission on China.

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