Tuesday, January 27, 2015

Should Reversing QE Come Before Raising Interest Rates?

As the economy improves changes in Fed policy is likely but what action the Reserve will take is open to debate. The question was proposed by Tim Worstall in an article entitled, Should The Fed Raise Interest Rates Or Reverse QE First? It is an important one as policy makers decide what they are going to do with this long-term debt while still trying to support America's re-emergence.

It should be remembered that the purpose of QE was to stabilize the banking system that found itself without capital reserve not too long ago. As a crisis aversion tool the goal was to increase government debt through the buying of securities thereby putting more electronic cash, hence reserves, into the banks to avoid major defaults that could have dragged the economy down.  It became a crisis averted by transferring risks from the private sector to the government.

As a policy stabilization made sense during a bank crisis but makes less sense as the economy recovers. The need to keep the liquidity of money flowing throughout the economy has dissipated and QE has stopped. According to the Heritage Foundation debt moved from $870 billion to $4.4 trillion in 2014. The nation must now deal with this debt and find ways of pushing it back into the private sector.

Sustained debt has an increasing risks to a nation that seeks to enhance its economic position. As debt levels rise, the cost of servicing that debt also increases which has an impact on growth rates (Turner & Spinelli, 2012). In comparison, European nations have experienced a flatter growth rate due to unsustainable debt levels. Maintaining such high debt  not only causes a drag on the economy but also increase risks of impotence when and if future crisis occur. 

Higher amounts of debt ratios, as a percentage of Gross Domestic Product, eventually raises interest rates (Hsing, 2010). Higher T-bill rates also caused inflation to move upwards over the long run. Debt levels, interest rates, and inflation seem to have a connection that creates the right framework for economic growth. 

Raising interest rates helps fight against inflation. By making money less available the government can ensure that growth stays within its target rate and doesn't heat up too quickly. By returning the debt back to the private sector it will fight against inflation by soaking up extra electronic currency that stimulates short-term demand.

Instead of officially raising interest rates it may be better to start unloading the debt in adjustable chunks giving the Federal reserve an opportunity to gauge the economy and its momentum at each stage. This will give more control to the government, raise interest rates, and work toward better debt management processes. Moving debt off of the balance sheet may just help us out in the future if another economic crisis rears its ugly head.

Hsing, Y. (2010). Government debt and long-term interest rate: application of an extended open-economy loanable funds model in Poland. Managing Global Transitions, 8 (3).

Turner, D. & Spinelli, F. (2012). Interest-rate-growth differentials and government debt dynamics. OECD Journal: Economic Studies.

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