The U.S. Federal Reserve is widely expected to pull a crucial economic lever for the first time in nine years Wednesday, boosting its benchmark short-term interest rate by a quarter of a point and edging it up gradually after that. The move will mark the end of the central bank’s emergency response to the 2007-09 financial crisis.
While investors are biting their nails over potential market fallout from the expected rate hike, economists are taking stock of the historically unprecedented monetary policy decisions that followed the crisis.
“What the Fed saw was a gaping hole in the economy,” said Peter Conti-Brown, financial historian at the University of Pennsylvania's Wharton School of Business. “The efforts to fill in that hole as best they could led to real experimentation.”
When then-Fed Chairman Ben Bernanke lowered the Federal Funds rate to virtually zero during the crisis -- making it all but free for banks to borrow money from the government -- some observers predicted catastrophe. Runaway inflation was around the corner, they said. Asset bubbles to rival the subprime mortgage boom were waiting in the wings.
But as current Fed Chair Janet Yellen prepares to ease the Fed off near-zero interest rates, it’s clear that not all of those dire predictions have been borne out. And the lessons learned, economists say, aren’t so simple.
Here are four dire predictions about the Fed’s zero-interest-rate policy -- and how they fared.
1. Runaway Inflation?
As the Fed embarked on the era of rock-bottom interest rates, the most commonly raised fear was that uncontrollable inflation would soon take off, as famed economist Arthur Laffer argued in a 2009 Wall Street Journal op-ed.
“We can expect rapidly rising prices and much, much higher interest rates over the next four or five years,” Laffer wrote, predicting “devastating” consequences and harkening back to the soaring double-digit inflation of the 1970s.
Those concerns grew more strident when the Fed doubled down on its stimulative efforts with an expanded asset-buying program known as quantitative easing in November 2010. In an open letter that month, a group of 21 economists, financiers and politicos warned Bernanke that the strategy of buying up trillions of dollars in bonds with interest rates so low would “risk currency debasement and inflation.”
Five years later, however, inflation is barely visible. The year-over-year measure most closely watched by the Fed, which tracks prices consumers pay for goods excluding food and energy, hasn’t hit its 2 percent target since April 2012.
“We’ve have had an extraordinary amount of money printed, and [the Fed] can’t even get inflation up to their target,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy.
Conventional wisdom would argue that the Fed’s asset-buying, combined with its rock-bottom interest rates, would soon enough spur a tick up in inflation. Typically, a central bank can then lift interest rates to slow inflation as it accelerates.
But with an economy slow to recover from the worst financial shock since 1929, demand simply hasn’t been strong enough to push prices up, said Josh Bivens, research director at the progressive Economic Policy Institute. Laffer and other inflation hawks “wildly underestimated how far from full potential we were,” Bivens told International Business Times, noting that wage gains have only just recently shown increasing momentum.
“It’s tempting to say that these prophets of doom were false prophets,” said Conti-Brown. But even though inflation never rose to the levels some feared, some worry that the monetary policy of the past decade could still spur inflation in the future. All the mortgage-backed securities and Treasury bills the Fed bought must someday return to the market.
“How is the Fed going to unwind that balance sheet without unleashing significant inflation?” Conti-Brown asked. That question has yet to be answered.
2. Asset Bubbles?
More insidious than inflation was the risk that the Fed’s easy money policies would touch off another asset bubble, even as the global economy was limping away from the wreckage of the 2008 mortgage implosion.
As the thinking goes, cheap credit would encourage excessive risk-taking in financial markets as hedge funds and investment bankers rushed to pour their essentially free money in whatever would post strong returns.
St. Louis Fed President James Bullard has called the possibility of an asset bubble a “significant risk for U.S. monetary policy.” Bernanke has also acknowledged such a danger, writing earlier this year, “In light of our recent experience, threats to financial stability must be taken extremely seriously.”
Could there be a Fed-driven bubble hiding somewhere in the market today? It’s hard to say. Part of the challenge in forestalling asset market bubbles is simply detecting them.
“It’s very difficult to pinpoint where the problems in the financial system are going to blow up,” Wessel said.
What is clear is that financial markets have grown tremendously since the depths of the financial crisis, driven in part by the Fed’s enormous asset purchases. The value of the Dow Jones Industrial Average has nearly tripled since its 2009 nadir, and corporations have issued $4.8 trillion in investment-grade debt since 2010.
While financial market growth has partly reflected a reviving economy, some have questioned whether the fundamentals in certain sectors justify the soaring valuations, particularly in technology. In May, Yellen admitted that “equity-market valuations at this point generally are quite high.”
But there are no obvious candidates for a market segment that could be the subprime mortgage bubble of tomorrow. “I don't see any obvious major mispricings. Nothing that looks like the housing bubble before the crisis, for example,” Bernanke said in October -- before adding, “But you shouldn't trust me."
A recent paper presented at the San Francisco Fed attempted to iron out the question. In a cost-benefit economic model, the economists found that the benefits from looser monetary policy -- namely, lower unemployment -- outweigh the financial risks.
“You have to think about the alternative,” Wessel said.
3. Heightened Inequality?
Though most of the criticism lobbed at the Fed in recent years came from the political right, left-leaning skeptics have also emerged, assailing everything from the Fed’s crisis-era loans to distressed banks to Fed officials’ professional ties to those same institutions.
Lately, they have taken a new tack. The Fed’s easy money policies benefited big banks and speculators more than humble savers dependent on interest income, they say. Consumer advocate Ralph Nader published an open letter earlier this year laying out the argument.
“We want to know why the Federal Reserve, funded and heavily run by the banks, is keeping interest rates so low that we receive virtually no income for our hard-earned savings while the Fed lets the big banks borrow money for virtually no interest,” Nader wrote.
As former bank executive and author William Cohan has argued, Fed policy “adds to the problem of income inequality by making the rich richer and the poor poorer.”
Indeed, times have been tough for older savers, especially those living on fixed incomes and cash savings. “It is unquestionably true that lower interest rates for those retirees and others who depend on fixed-income securities have hurt,” Conti-Brown said.
But that analysis leaves out the counterfactual, Conti-Brown added: “What if interest rates were higher and the economy was even more devastated?”
In a response to Nader, Yellen noted that without the Fed’s policies “many of these savers undoubtedly would have lost their jobs, or pensions (or faced increased burdens from supporting unemployed children and grandchildren).” The benefits to employment, Yellen said, far outweigh the pain humble savers felt.
As elsewhere, low interest rate policy remains a tradeoff. “You can’t make any policy that is completely good for everybody,” Bivens said.
4. A Weaker Dollar?
Dovetailing with inflation concerns, some economists greeted the Fed’s easy money policies with warnings that the dollar would sink against stronger currencies abroad. International investors are less likely to park their money wherever interest rates are low. By flooding the market with new cash, the Fed made the dollar less attractive for foreign investment.
In April 2011, a CNBC headline warned that investors vexed by the weak dollar should “get used to it,” as a combination of monetary tightening in Europe and deeper asset purchases by the Fed sent the greenback sinking.
That trend would quickly reverse, however, to the point that Fed officials have repeatedly cited the strength of the dollar as an inhibitor to U.S. economic growth. According to the New York Fed, a 10 percent appreciation of the dollar in one quarter takes a 0.5-percent bite out of gross domestic product.
The stronger dollar, said Yellen earlier this month, “makes us more cautious in terms of raising rates.”