Lacker Dissents From FOMC Majority

January 28, 2009

The FOMC statement released today was not much different from December’s communique. There was no change in the Fed funds target, which is already pinned in a range centered on 0.125%. Some officials in the U.S., as at the ECB and Bank of Japan, fear that going all the way to a point target of zero might do irreparable damage to the money market and hinder implementation of a tighter stance when recovery eventually begins in the economy.

Incremental easing changes in policy must therefore be introduced by quantitative actions.  The FOMC mentioned the same three actions that were addressed in December’s statement.

  1. Buy large amounts of agency bonds and mortgage-backed securities.
  2. Officials are prepared to buy long-term Treasuries once they deem such to be an effective way to improve private credit market conditions.  This language indicates the FOMC is closer to giving a “go” to this step than in December, when the FOMC authorized an evaluation of the pros and cons of buying long-term Treasuries.
  3. A Term Asset-Backed Securities Loan Facility to direct credit from the Fed to households and small businesses, bypassing banks, is being launched.

The Fed is sticking to a selective, rather than general, approach to getting badly needed funds to would-be borrowers.  Jeffrey Lacker, President of the Richmond Fed, wants a blunter strategy that essentially would reverse the process used to kill inflation nearly 30 years ago when Paul Volcker was Fed Chairman.  Lacker dissented from the majority in favor of expanding the monetary base (MB) by “purchasing U.S. Treasury securities rather than through targeted credit programs.”  Presumably, the Fed policy would target growth in the MB, and market demand would determine the yield on long-term Treasuries.  Lacker’s motion has compelling merit. In times of emergency, the credibility of policy can be enhanced by introducing a target, so that decision-making has a little structure and is not completely seen as seat-of-the-pants steering.  An inflation target would be great but cannot be adopted without the authorization of Congress.  Targeting the monetary base, high-powered money if you will, doesn’t require the input of Congress.  Securing adequate growth in the monetary base would reduce the long-term risks of deflation, that is a sustained decline in general prices for goods and services.  Having that safeguard in place would in turn help anchor medium-term price expectations in a time when actual CPI inflation at 0.1% year-on-year is poised to move into negative territory.

The FOMC statement, as I expected, devoted more space than usual to a discussion of current economic conditions and prospects.  The assertion that the economy weakened further in the past six months states the obvious, although there is some ambiguity over whether “weaker” refers to a bigger rate of decline in real GDP or a lower level of GDP.  Each is true.  Industrial output, housing, jobs, foreign demand, consumption, and business investment are explicitly mentioned as trends of decline and significant downtrends in many cases.  Credit conditions are called “extremely tight,” although officials concede some areas of the market that have responded positively to policy stimulus.  Inflation will “remain subdued in coming quarter,” possibly too much so.  On a less hopeful note, “the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer room.”  In light of heavy recent criticism of Alan Greenspan’s proactive crusade against deflation early this decade, the D-word is avoided, but the gist of this sentence seems to be that deflation cannot be ruled out.  Indeed, while the statement predicts “a gradual recovery in economic activity later this year,” it adds that “the downside risks to that outlook are significant.”  Such a “tail” result would create fertile ground for a much more severe recession than not contemplated. I suspect the minutes of today’s meeting will include much more discussion of the possibility of deflation than today’s statement reveals.  Remember that substantial consumer price and producer price deflation was a hallmark that set the 1930’s apart from even Japan’s more recent multi-year experience with falling prices, and the Fed’s great error from that era was to watch nominal interest rates but ignore rapidly imploding money growth.  Lacker’s proposal would not allow money growth developments to fly under the radar.

Copyright 2009 Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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