Hicks: Fed’s easing plan barely makes an impact

The Federal Reserve’s recent decision to ease efforts to stimulate the economy were widely expected, though I thought it might wait another month until the new Fed chief, Janet Yellen, took the helm. What was unexpected about the announcement was just how minimal the changes were.

To remind readers, the Fed is now actively engaged in something known as QE3, or the third round of quantitative easing. This involves buying government bonds and mortgage-backed securities from banks. That process injects $85 billion each month directly into the economy. 

According to a traditional money multiplier analysis, the effect on the actual money supply ought to be equal to $85 billion divided by the reserve requirement of banks, which is less than 2 percent. So, $85 billion divided by 0.02 is $4.25 trillion in additional money per month if banks were to lend it out. Over 2013, that is more than $51 trillion in "potential" new money created by the QE3. This is more than three times the size of the U.S. economy and more than nine times the money we need for transactions each year.

I apologize if you are scared by the math, but, trust me, it is the number of zeros that is the most terrifying. Clearly, that growth in the overall money supply is not following this simple money multiplier. We know this because we still have low inflation. The challenge is that this transmission mechanism of the Fed’s monetary policy to the overall economy is weak. It hardly matters whether the size of the QE3 is $75 billion or $85 billion a month. The question is simply, why is this level of monetary growth not having a more visible effect?

To explain it simply, businesses borrow money to buy capital equipment, from which they can expect a rate of return. If the market interest rate is beneath the rate of return for this capital, then borrowing makes sense. If the market interest rate is above the rate of return on this capital, then businesses will not borrow. Thus, the Fed depends upon the actual rate of return on capital, which economists term the natural rate of interest.

The natural rate of return on capital obviously varies for different businesses in different locations. The problem is clearly that, for many businesses in many places, that rate of return is beneath the astonishingly low market interest rates. This stifles growth.

Of course to many, this is all financial market shenanigans played out by rich people in pinstriped suits. The actual effects of this read into labor markets, for if the return to capital investment is too low to stimulate borrowing, hiring will also be stagnant. That is where we now are.

The Fed’s slowdown of monetary stimulus was too small to have any real negative effect and that is why Wall Street is untroubled and stocks fly high. Clearly, 2014 is going to be a long, slow year for our economy.•

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Hicks is director of the Center for Business and Economic Research and a professor of economics at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.