The Fed Acts

Well it had to sometime. No one else is doing anything.

Only a few days ago I expressed a certain dismay that Ben Bernanke said a lot of the right things in his Jackson Hole speech, but then had done nothing. He articulated exactly why the Fed ought to act, and act aggressively, and then fell silent. It looks as if he was waiting for one more rotten employment report before he could gird himself for the fight.

And he saw that report last week. With the economy’s abysmal not very good job creation lingering, as evidenced by last week’s paltry increase in payrolls, time had run out. It took a while for the Fed to realize that it has two policy objectives and not one. The first – battling inflation – has so dominated Fed thinking that the second – helping maintain full employment – scarcely gets a look in. Typical of central bankers everywhere the Fed has become a slave to low inflation. Even when that means damaging the employment outlook.

Targeting inflation has its merits. Price stability, after all, has a lot going for it. And there are times when hammering inflation is worth the short term loss of jobs that seems inevitably to accompany the necessary disinflating. Nonetheless the obverse must also be true. There are times when letting inflation creep up is worth the boost to employment. In other words the trade off between employment and inflation is an active and ongoing compromise working in both directions. We seem to have forgotten that. So with our central bankers obsessed by inflation the unemployed were thrown on the mercy of fiscal policy, which as we know is so politically fraught as to be nonexistent much of the time – Obama’s way-too-weak stimulus notwithstanding.

Today that changed somewhat.

The new round of monetary policy – called QE3 – is remarkable in a couple of key respects.

First, it is open ended. The Fed has set no specific timetable for its purchases, saying only that it will monitor trends and keep up its action as long as necessary.

Second, it is going to focus its purchases on mortgage backed securities rather than Treasuries. According to Bernanke this is in order to bolster the real estate market, and to provide support at that end of the risk spectrum.

Oh, one more thing, the Fed also extended its low interest rate target period by a further six months. This means it is not expecting to raise rates until mid-2015. This extension alone is depressing. It implies that the Fed sees high unemployment persisting for a long while yet. Perhaps more intriguing was the comment that the Fed intends to keep low rates even after the recovery gathers steam. So we ought not to experience the usual rough tightening that central bankers love to impose the moment they see growth. This time the Fed is committed to allowing growth to build momentum before reacting. At least that’s the story for now.

So. What does this mean?

I think I am on the cautious side with this. In an economy going through a debt reduction of the scale we are, lowering interest rates is a more blunt tool than under normal circumstances. Plus the lack of demand is the driver of low business investment, not the cost of borrowing. So with households still gun shy over taking on more debt, and with businesses skeptical about the need to expand operations, the stimulative impact of cheaper money is lessened.

Having said that, with fiscal policy contorted and neutralized by our political impasse, the Fed’s action is the best we can hope for in the near term. So we ought to applaud and keep our fingers crossed. One of our two doctors noticed our malaise. Unfortunately the wrong one. Better that than nothing.

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