Daily Archives: September 13, 2012

Through both its actions and what it refrained from doing, the Federal Reserve confirmed on Thursday that it is operating in policy purgatory: incapable of delivering the good economic outcomes it desires, yet unable to exit from an experimental policy stance that risks a widening array of collateral damage and unintended consequences.

To grasp the Fed’s policy dilemma, we must first discuss the why and what of additional unconventional Fed measures.

Three realities anchor the case for additional measures, notwithstanding the fact that the results of prior policy interventions actions have consistently fallen short of policymakers’ own expectations.

First, the FOMC reiterated concerns about the country’s economic prospects, and rightly so. It echoed Chairman Ben Bernanke’s speech at Jackson Hole on August 31. There he cited America’s “daunting economic challenges,” including the “grave concern” of a stagnant labour market where high unemployment – even if predominantly cyclical in nature as Mr Bernanke believes – would get embedded in the structure of the economy were it to persist for long.

Such worries were accentuated in the last week by the disappointing August employment report, as well as the more recent high frequency jobless claim data released earlier on Thursday. Both confirm weak job dynamics. They come at a time when long-term and youth unemployment is way too high, Americans are dropping out of the labour force, poverty is on the rise, and income inequality is widening.

Second, the Fed is not helped by the fact that it is the only entity properly engaged in addressing America’s challenges. Others, including those paralysed by deep congressional splits, are standing on the sidelines even though they have better suited policy instruments.

Then there are the unusual “tail risks” facing the economy and additional policy insurance they appear to warrant – from the threat of the European debt crisis to the self-inflicted fiscal cliff in the US and mounting political risks in the Middle East. If even one were to materialise, America would soon find itself again in a recession which would accentuate economic, financial, political and social fragilities.

With this in mind, Fed officials decided to experiment even more. They extended forward guidance, stating that policy rates are expected to stay exceptionally low “at least through mid-2015”. Importantly, they also committed to additional, open-ended purchases of mortgage-backed securities (what will likely be labeled “QE3”).

History and detailed analyses of the problems underpinning America’s prolonged economic malaise suggest that these well-intentioned measures will again fail to secure a much better economic situation. This is also behind the widening gap between economists urging the Fed to do even more and those favouring less.

In refraining from going beyond forward guidance and QE3, the Fed is seeking to balance these two competing views. It thus refused to cut the interest it pays on excess reserves (IOER) despite some arguing that this would induce banks to lend more to the real economy and thus encourage greater economic activity. It also declined to move from an intermediate policy target (boosting asset prices) and time commitment (mid 2015) to specific economic targets (including nominal GDP).

With both options having been discussed by Fed officials, their revealed preference speaks to important considerations that will grow in the months ahead.

They signaled growing recognition of the “costs and risks” of unconventional policies – from undermining the functioning of certain market mechanisms to hampering entire segments that provide financial services to citizens (such as money market accounts, life insurance products and pension coverage). For example, a cut in the IOER would have dealt an even bigger blow to the money market industry. They also reinforced Mr. Bernanke’s earlier view that “monetary policy cannot by itself [deliver] what a broader and more balanced set of economic policies might achieve.”

Like the ECB, its Frankfurt-based European counterpart, the Fed cannot by itself secure the results that so many desire – high growth, robust job creation and financial stability. At best, it can keep buying time in the hope that other government entities will get their act together. Until this happens, the Fed will remain in policy purgatory.

Mario Draghi’s bond buying plan has restored some control over interest rates in those parts of the eurozone which, it seemed, were in danger of becoming detached from the European Central Bank mothership. While many in the private sector harbour doubts, the ECB president has to be fully signed up to the euro’s survival. It can therefore justify purchasing assets that others might regard as untouchable. And with yesterday’s qualified ratification of the EU bailout programmes by the German constitutional court, the ECB can look back on an effective week.

Yet problems remain. To get their hands on the ECB’s largesse, countries have to sign up to austerity and structural reform programmes. That’s entirely understandable. No one – least of all, the Bundesbank – wants to see the ECB writing unconditional cheques to renegade governments with dubious fiscal ambitions. However, no government will want to sign up for blank cheques if the cost ends up being excessive austerity and political downfall – one reason why Mariano Rajoy, Spanish prime minister, nervously looking at Catalonian protests, has yet to buy into the ECB’s plan.

Imagine that a country volunteers for the ECB’s deal. Once the European Financial Stability Facility or the European Stability Mechanism buys in the primary market, the ECB buys bonds in the secondary market at the short-end of the yield curve, ensuring relatively low interest rates.

There are then two risks. The first is the danger of fiscal backsliding. If the country fails to deliver – perhaps because the regions are recalcitrant or because the electorate is uneasy – does the ECB, doubtless prompted by the EFSF/ESM, withdraw support? The answer surely should be “yes”. In the eurozone, however, failure in one country has a nasty habit of infecting others.

The second, more worrisome challenge, is the possibility that even with low interest rates, economies may still end up slipping into recession, thanks to a combination of fiscal austerity and losses of competitiveness. We surely know by now that monetary policy has its limitations. The Bank of England, for example, has been able to deliver remarkably low interest rates, quantitative easing and a much weaker currency, yet the benefits of these policies have not been good enough to prevent a return to – admittedly shallow – recession.

Let’s say that Spain or Italy stays in recession – or, worse, that their current recessions deepen – despite the help provided by the ECB. Budget deficits might then end up spiralling out of control even if governments were sticking to austerity measures pre-agreed with the higher powers. The European Commission rightly focuses only on “structural”, not “cyclical”, deficits but disentangling one from the other in the midst of ongoing stagnation has become nearly impossible. A cyclical deficit is only cyclical if there is eventually recovery.

The Stability and Growth Pact, the EU’s fiscal rulebook, allows for delays in fiscal consolidation if the excess deficit “results from a negative annual GDP volume growth rate or from an accumulated loss of output during a protracted period of very low annual GDP volume growth relative to potential”. Importantly, however, “the excess … shall be considered as temporary if the forecasts provided by the Commission indicate that the deficit will fall below the reference value (3 per cent of GDP) following the end of the … severe economic downturn.” This is a another way of saying that there is a risk of fiscal tightening at the wrong time, locking in recession and stagnation for the long term.

The “circuit breakers” – allowing countries to postpone the day of fiscal reckoning – do not seem to be flexible enough. In contrast, for example, under the Gramm-Rudman-Hollings law, US deficit reduction was to take place each and every year in the late-1980s and early-1990s but the process would be automatically suspended in the event of a recession or weak growth: there was a bias against pro-cyclical fiscal tightening. But in the eurozone, this type of bias is hard to find.

What if such a bias was introduced in the eurozone? It might be a good thing for growth but, to the extent that fiscally-weak countries would then become even more dependent on handouts. it would only serve to emphasise the limits beyond which monetary policy cannot go. Ultimately, successful monetary unions are invariably successful fiscal unions too. Mr Draghi’s actions, the German Constitutional Court ruling, or the Dutch election do little to change that conclusion.

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