Reaction to Federal Reserve's Radical Medicine

December 17, 2008

To paraphrase Churchill, the easing of Fed policy seems to have reached the end of the beginning. Zero central bank interest rates, popularly known by the acronym ZIRP, are virtually in place now. Policy from here will be measured by quantitative criteria, specifically the size of the Federal Reserve’s balance sheet. Such already had soared 145% from the first week of September to $2.22 trillion by December 11th and will surpass $3.0 trillion early in 2009. U.S. monetary policymakers intend to convince investors that their rates will remained pinned at zero for “some time” and to depress a wide range of other interest yields by buying up a diverse range of financial assets. It will be using the proverbial money printing press overtime in hopes of forestalling deflation and flattening the recession until such time as banks and other private financial institutions reassume their traditional role as intermediary and risk taker.

The Fed has its doubters. The dollar, one of the best barometers of investor comfort with central bank policy, has reacted poorly. At today’s lows, the euro had retraced nearly 57% of its prior downward correction from $1.6038 to $1.2331, and the yen had penetrated deeper into the 80’s, reaching 87.15, 28.6% above its 2008 low and 42.8% stronger than its June 2007 low of 124.14/$. Commodity currencies like the Canadian and Australian dollars had each retraced slightly more than 25% of their extensive corrective declines from respective highs of $0.9061 in November 2007 and $0.9849 last July. Even woeful sterling had advanced nearly 9% to $1.5723 from a recent low of $1.4471, thereby reversing three-sixteenths of its slide from a high in November 2007 of $2.1160.

Financial Times columnist Martin Wolf has written a skeptical editorial in today’s edition, which lays out the specter of future inflation and flight from the dollar as risks, and he also blames the last Fed fight against deflation for partly setting in train the sequence of events leading to the current policy crossroads. Wolf rightfully cites the irony of a central bank attacking present problems with the same policy remedies used some six years ago that are responsible in large part for the current problems.

The review of the Fed statement written in this weblog yesterday observed that the Fed may have crossed a line whereby it will be very difficult to reverse policy in a timely fashion. And that assumes that the Fed threads the needle between deflation and inflation. Those extremes had been considered very wide apart, but 2008 underscored that the universe of all economic possibilities is much smaller than assumed previously. Price expectations play a key role in this world-shrinking process, and the ride of oil prices from $87/barrel early last February to a peak of $147 in July and then down to $40 earlier this month underscores how unglued such expectations have become. Perhaps the biggest conundrum of 2008, and there have been many, is that economists and market participants cannot decide whether to fear inflation or deflation, and the psychology of fear that hovers over consumers, business leaders, bankers, and investors indeed embodies both. One way or the other, one of these enemies of economic well-being is seen striking the United States and much of the rest of the world economy.

The Wall Street Journal editorial board has been a consistent critic of Fed policy all this decade. Since Chairman Bernanke was as a Fed Governor an outspoken supporter of the Greenspan Feds attack against possible future deflation in 2002-3, he epitomizes what the Journal considers very ill-advised policy, and that paper also opposes the substantial spending increases being cooked up by the incoming Obama administration. Today’s Journal runs a sarcastic opinion piece, entitled “Bernanke Goes All In” and quotes former Fed Chairman Blinder who said, “the Fed gets an A or A- for effort and not very good marks for results.” The Journal disagrees that insufficient liquidity is the main problem, identifying instead as the main culprit the lack of confidence, abundance of fear, and high level of uncertainty. Supply-side economics provides the ideological compass at the Journal, and “a major tax cut” is its answer to every economic problem. Today’s editorial opposes loosening monetary policy with the dollar at already-depressed levels, and makes another plug for a big tax cut. Yesterday’s editorial documented the chronology of failed Japanese public spending programs, leaving the impression that a similar record of futility awaits future U.S. extra deficit spending.

Here’s what the Journal repeatedly neglects to explain. If major tax cuts are the optimal macroeconomic policy for all occasions, how come the U.S. economy has performed so much worse during the presidency of  a tax cutter like George Bush than during the administration of Bill Clinton, which put top priority on reining in the Federal budget through policies that included higher taxes?  Comparisons of real GDP growth, employment growth CPI, stock market performance and the dollar were examined in previous posts on this site and can be visited by clicking on  Part of the supply-side creed is the belief that the private sector is far more trustworthy and efficient than government in almost all activities. The Madoff scandal is only the latest example of the perils of deregulation carried to the extreme. Activity in the public and private sectors both reduce to reliance on human behavior, which is prone to stray. The excesses of each need to be checked and balanced by the other. Some economic projects can be best done privately, and others are better suited for the public sector. When power is overly vested in either, trouble follows.

The Journal and Wolf column are right to observe that policy changes thus far have not restored a functional financial system nor averted a global recession. What we do not know is what might have happened if there had been no policy response, or if the only collective response had been major tax cuts by many governments. It’s possible, and even probable, that no combination of policies could have avoided a multiyear period of severe economic pain. It just might be the case that there was and is more to fear than fear itself.

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