This is an historic time. After six years of the most novel and expansive monetary policies since its creation 100 years ago, the Fed is finally ready to admit its role in prolonging the current recession… kind of.
Two economists at the Federal Reserve branch in St. Louis recently wrote a commentary blaming the sluggish recovery on consumers more interested in “hoarding” cash then spending. Not much of a surprise there, but the two reasons cited as to why consumers have a change of heart are telling.
1. Increased uncertainty because of the crisis has caused an increase in money holdings.
2. The low interest rate policy of the Fed has removed much of the incentive to invest that consumers used to be faced with.
Put the two together, and you quickly see how the Fed is culpable. The tradeoff of investing is holding your savings as a cash balance. Since investment returns are dismal because of the Fed’s efforts to keep interest rates pegged to the floor, consumers are not foregoing much return by putting their hard-earned savings in illiquid investments. Better to keep that cash in the bank. Couple that with the fact that uncertainty from the recession already increased peoples’ precautionary demand for cash, and you get a tidy little explanation for why spending is down and why bank reserves are at record levels.
Of course, my own explanation above, pinning the blame directly on the Fed, couldn’t possibly get nods of agreement from any Fed economists, could it? Indeed, as the authors of the aforementioned study conclude (and I concur):
In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).
(Cross-posted at Mises Canada)