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The dirty little secret of monetary policy is that, over the long term, it cannot produce sustained growth, reduction in unemployment, or new entrepreneurial activity.

Many Fed observers were hoping Chairman Bernanke would announce a second round of quantitative easing at the Fed’s annual symposium at Jackson Hole this past weekend.  He didn’t, and he likely won’t.  Monetary policy can’t do more to fix the economy.

For those of you who don’t study monetary policy for a living, quantitative easing is a fancy way of saying that the Federal Reserve buys financial instruments in order to expand the supply of money to a certain target size.  The chart above shows the holdings on the Fed’s balance sheet from 2007 to the present and notes the two quantitative easing programs that the Fed has run.  As you can tell, they have expanded their holdings substantially from their relative stable status quo before.  As you can tell by living and working in the United States, it doesn’t seem to have worked.

The Fed engages in monetary expansion in order to spur growth and development.  In simple terms, having more money in the economy enables more people to do more things.  The play is a bit of a gamble.

Economists make the distinction between the “real” economy – where goods and services are produced, bought, and sold – and the financial markets – where options, futures, derivatives, equities, bonds, and the like are traded based on activity in the real economy.  Financial market participants make decisions based on what is happening in the real economy.  Quantitative easing reverses the signals to investors as it spurs a change in the financial markets in order to produce changes in the real economy.

At the moment, our fundamental crisis is in the real economy; we need more jobs.  Quantitative easing hasn’t – and can’t – give us more jobs.  The graph below shows the path of monetary expansion, as above, alongside the unemployment rate.  As you can tell, expanding the amount of money available hasn’t created new jobs.

Actually, at a statistically significant level (R is high), there is a strong correlation between an expansion of the money supply and unemployment.

The uncomfortable truth is that the Fed can’t fix the real economy.  Over a short period of time, expanding the money supply might succeed in producing inflation fast enough to exceed wage increases.  The result would be that real wages fall.  Even if people are making more nominal dollars, they would be making less money than they were before because their dollars would have less purchasing power.  Companies would find themselves with lower labor costs and see an opportunity to hire more workers.  However, workers would not simply settle for less purchasing power, and wage demands would increase quickly to compensate for inflation, negating the short-term job creation benefits.

It’s also worth noting that the rise in wages would trigger a rise in inflation expectations, and that would causes businesses to tighten their belts.  The fact that gold prices are trending astronomically high indicates investors are aware of this fact.

Ben Bernanke was once a respected Princeton professor who did ground-breaking work highlighting this reality.  While he has been chastised for not being as bold as his prior work said central bankers should be, he has walked the fine line of managing expectations while adhering to monetary theory.  Now, as Chairman of the Fed, he hasn’t forgotten his research; don’t expect QE-3 any time soon.