Fed Waiting for Godot

Guest Post

Testifying before the Senate Banking Committee today, Fed Chairman Bernanke did not move closer to fresh stimulus than his position in previous public comments including last month's post-FOMC press conference. Policymakers are prepared on a conditional basis to adopt further options, including perhaps a third round of quantitative easing, and the trigger for such action would be a failure of the U.S. economy to improve. This puts the FOMC in a waiting mode, but the time and size dimensions of that trigger have not been revealed. In all likelihood, that information hasn't been precisely quantified even internally because there are other as-yet unknown market-based factors that will have to be considered, too.

The Fed has two mandates, and both are missing in a direction that supports greater stimulus and employing such with more force. Assuming that real GDP expanded about 1.5% annualized last quarter, such has risen 1.6% annualized over the past six quarters, which is only half as fast as the growth of 3.0% annualized during the first six quarters of the present economic upswing. To be sure, the three-year growth rate of 2.3% annualized between mid-2009 and mid-2012 was just a tad less than the 2.45% per annum longer run growth rate desired by monetary officials, but that pace followed the deepest recession since the 1930s. From end-2007 when the Great Recession started to mid-2012, a span of 4.5 years, U.S. GDP advanced only 0.2% per annum, and that's weak enough to leave the disparity between potential GDP and actual GDP 10.5 percentage points greater than what such was before the downturn.

Without knowing anything else including the growth of money and credit — the latter being particularly weak — one could surmise that unemployment would be much more elevated now that predicted three years ago and that inflation would be excessively low as well.

• The jobless rate rose from 4.7% at end-2007 to 7.3% in December 2008 and 9.9% in December 2009, then settled back to 9.1% by mid-2011 when the second round of quantitative easing was finished, 8.3% in January 2012, and 8.2% at mid-2012. Unemployment has surpassed 7.9% since February 2009, and the improvement thus far from peak has been dominated by labor force drop-outs. Fed officials consider full employment to be meeting their mandate somewhere between 5.2% and 6.0% but project a jobless range in 2014 centered upon 7.15%.
• Consumer prices in the United States rose 1.7% between mid-2011 and mid-2012, down from 3.6% in the previous statement year. Over the four years between June 2008 and June 2012, consumer price inflation averaged 1.2% per year. Fed officials do not expect their preferred inflation measures, the core personal consumption deflator and the total PCE price deflator to surpass the 2.0% target before 2015 and project ranges for 2012, 2013, and 2014 that are centered below their mandate.

As best as one can discern, the primary reason that the FOMC hasn't already implemented a more aggressive stance involves self-doubt that the stimulus benefits from such would exceed potential collateral damage. Critics of the central bank have been warning of such damage to money market functionality, price stability and long-term interest rates. On the second two points, critics have been very wrong. Moreover, it's difficult to measure the cost-benefit tradeoff because it is not possible to know how the economy would have performed if quantitative easing or Operation Twist had never been tried. But one can imagine that the economic picture would not have been a pretty one if those decisions had been the ones the FOMC made..

A second reason for foregoing more forceful monetary stimulus is the view that fiscal policy is better suited to shoulder the macroeconomic burden going forward. That's certainly true. However, such action is not going to happen before the election, and only a leap of faith suggests that the prognosis for fiscal functionality will improve dramatically thereafter.

One is left to view monetary policy as increasingly faith-based. A base-line scenario exists that the sun will come up more brightly tomorrow, even though similar views about the labor market and other parts of the economy didn't pan out in the past. Officials can hold out hope as scraps of good news arise. Today's report of industrial production rising by 0.4% in July exceeded street expectations. So did the National Association of Home Builders index, which posted a six-point improvement in July, the biggest such advance in nearly a decade. It would be better, however, to be guided by the big picture rather than the constant stream of monthly data, which invariably give mixed signals. The above two bullet points underscore that Godot hasn't come, and that a strategy of letting time heal the economy's malaise is probably not the wisest approach.

Copyright 2012, Larry Greenberg. Currency Thoughts All rights reserved. No secondary distribution without express permission.