Cross-posted from Credit Writedowns
Federal Reserve Chairman Ben Bernanke is due to speak before Congress. Let me say a few words about what’s going to happen with the Fed.
Here’s the thing: The Federal Reserve Board is located in Washington, DC and Washington is a political town. As such, the Fed must mind its manners or it will find its mandate diminished…
the issue here is the politics of the matter. The Fed has already spent its political capital. And if you want a reason why the Fed isn’t doing anything about the renewed economic weakness despite Bernanke’s famous 2002 helicopter speech, this is it. The Fed knows darn well it has spent its political capital…
The reason the Fed isn’t doing anything is because they are saying in effect "central bankers alone can’t solve the world’s economic problems." The subtext being they feel politically constrained and will not act until they get political consensus that they should do so. Moreover, when you have Fed governors like Charles Plosser or Thomas Hoenig saying something different, it makes it difficult politically to go all in. So you wait.
Let me restate this: actually, David Beckworth and Scott Sumner are right; what the Fed really wants is higher nominal GDP. Now I wrote the paragraphs above in October of 2010, knowing that the Fed “may well have already begun some QE type stuff.” But my analysis said that QE2 would be small potatoes – what I call QE-lite – and that the aim would be boosting asset prices.
In retrospect this is exactly right; the Fed did not do rate easing or credit easing or ‘municipal easing’ (buying munis). And the Fed played up the asset market impact of its quantitative easing and played down the interest rate impact.
But what about inflation? Well, commodity prices rose during QE2 but that was not a positive happenstance for the Fed. So that tells you what the Fed want is higher nominal GDP, preferably from real growth rather than inflation. And we’re not getting that, nor could QE2 deliver that.
With Bernanke on deck, I think Mohamed El-Erian’s view on the politics of Fed monetary policy in in line with mine.
“Because the Federal Reserve has become a political target, it is in no hurry to have monetary policy displace fiscal policy in underpinning the economy, but it may be forced to do so given its dual mandate and the likelihood of fiscal contraction…
I do not expect QE3 now nor do I expect it unless the economy deteriorates further.”
“We would assign a low probability (at) this stage to QE3 given the general recognition that the forward-looking cost-benefit analysis has shifted away from the potential benefits and towards greater costs and risk…Therefore, it would take a major further deterioration in the economic outlook, combined with a willingness by the Fed to take greater reputational and political risks”
The FOMC is divided now. Tim Duy gets at the internal politics:
The discussion of the economic situation was markedly downbeat, even before the latest employment report, yet the final outcome of the meeting – the FOMC statement and Federal Reserve Chairman Ben Bernanke’s subsequent press conference – seemed to clearly indicate that, barring an outright return to the threat of deflation, the Fed saw its job as done. How can we reconcile these two positions? Presumably the faction leaning more toward additional easing is relatively small, while the majority believes either they have already gone too far or that further policy is ineffectual. Bernanke seemed to place himself in the latter category during the press conference. Is that really where he stands? This apparent divergence of views on the FOMC will bring extra attention to Bernanke’s testimony today on Capitol Hill.
So there you have it. The Fed could do a number of things: rate easing, municipal easing, inflation targeting, nominal GDP targeting – not that these things will be super effective in a balance sheet recession because even creditors shift to capital preservation when the likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession. (see here). But, still, the impotence of monetary policy doesn’t mean these things will have zero effect. If the Fed really jammed it on, the economy would most definitely respond. It is just that “the forward-looking cost-benefit analysis has shifted away from the potential benefits and towards greater costs and risk” of more monetary stimulus just as El-Erian has said. Unfortunately with fiscal policy also tightening, that spells economic weakness.