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The Fed lists things it could do, but won't
Jul 14th 2011, 19:06 by R.A. | WASHINGTON
THE financial press has been aflutter in recent days with stories of the form, "Fed opens the door to QE3". The burst of excitement is rooted in the release of minutes from the Fed's June meeting and in new testimony from Chairman Ben Bernanke. The minutes revealed that some members of the Federal Open Market Committee are concerned about the disappointing performance of the economy and are anxious to talk about how the Fed might act if necessary. And in testimony given yesterday, Mr Bernanke listed the options
available to the Fed:
Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.
The Fed is clearly not out of ammunition. It has "these and other potential alternatives" at the ready. But will it use them?
Well, it might. Mr Bernanke didn't actually open the door to QE3 this week, because the door was never really closed. But while the odds of additional easing have probably risen a bit, it still seems far more likely to me that nothing will be done.
The Fed has a dual mandate, but it behaves as though price stability is its only remit. Have a look at the path of the employment-population ratio:
If the Fed were taking the full employment part of its mandate seriously and thought a large programme of quantitative easing made sense in 2009 and again in 2010, then it's difficult to see how additional action isn't warranted now. The dual mandate is a joke. What the Fed does care about is inflation. Have a look at this chart of implied inflation expectations, from Tim Duy:
It took a substantial decline in inflation expectations to get the Fed to engage in QE2. Since the spring, expectations have fallen again, but they remain well above the levels that are likely to get the Fed to act. The Fed, for whatever reason, has abandoned any effort to address the employment gap. It's only mission now is to avoid deflation.
And as Mr Duy argues, that means that additional action probably isn't forthcoming. Core consumer price inflation fell below 1.0% last summer, prompting a Fed response. Now, core inflation stands at 1.5%. Headline inflation figures are falling, of course, thanks to recent declines in commodity prices. It's less clear that core inflation will drop very much anytime soon, not least because rents—a substantial component of the price index—are rising. And because Mr Bernanke is probably right that growth will pick up in the second half of the year, putting a floor under disinflation.
I find this...frustrating. Rising rents are driven by real scarcity; an increase in inflation associated with rent increases isn't a sign of a monetary-induced upward spiral. The outlook for growth is improving, but it was also improving in the spring and late fall of 2010 and as we see above this translated into virtually no closing of the employment gap. Growth was neither strong enough nor sustained long enough to make a difference. Most importantly, with labour markets extraordinarily weak there is no sign of significant upward pressure on wages. The Fed has tools, as it freely admits. Its mandate demands that it use them, and the economics of the situation suggest that it could use them without touching off much in the way of inflation.
My guess is that the Fed will only act if crisis in Europe or a bad outcome in American debt talks lead to a sharp drop in growth and inflation expectations. Otherwise, it will stand by waiting, ever vigilant, for the first sign of troublesome inflation. Mr Bernanke is like a man with a jack walking by a car with a blown tyre but refusing to act lest the driver run a bit over the posted speed limit.
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