As the Fed sleeps

September 23, 2009

It’s not even October and the Federal Reserve already appears to be going into policy hibernation.

Today’s statement appears intended to attract as little attention as possible. Even the more gradual tailing away of mortgage purchases by the Fed seems calculated to assist the Fed’s quiet retreat.

There will be no further efforts by the Fed to accelerate the pace of growth. Given the grim economic outlook this is a shame. Today’s Fed statement pointed to a pickup in growth, but the Fed’s own economic forecasts still scream out for stronger action.

Even through 2010 unemployment is expected to hover close to 10 percent. Core inflation meanwhile could go below 1 percent in 2011. This is the kind of outlook that would normally prompt the Fed to stamp on the accelerator.

Sadly, the Fed no longer has this option. Ben Bernanke is hemmed in on two fronts.

The first is a political constraint. The doubling of the Fed’s balance sheet during the crisis alarmed many in Congress. As the financial crisis has receded, there seemed less justification for such extraordinary action.

The Fed now badly needs to win back support in Congress. The stakes are high as lawmakers prepare to overhaul the regulatory framework. Not only does the central bank hope to win the new role as systemic regulator, they may need to fight hard to avoid encroachments on their independence by Congress.

They will be particularly keen to prevent oversight by the Government Accountability Office. Such political pressures explain why the Fed’s last significant public announcement was a populist initiative to curb financial sector bonuses.

The second limitation is of their own making. It results from a failure of nerve. The Fed was too quick to sound the retreat on credit easing. Soon after financial conditions started to normalize and fears of depression eased, the Fed indicated that the balance sheet would not expand any more than had already been planned.

This was premature. The Fed could have added another trillion dollars to its holdings without generating inflationary risks or unsettling the markets. By raising the potential ceiling on their asset purchases Fed officials would have given themselves much more room to pursue the goal of full employment.

Now, however, the Fed appears to be locked into its sleepy strategy. To reverse course and expand asset purchases would throw the market into turmoil and undermine Fed credibility. The damage to the Fed’s inflation-fighting credentials could actually push up interest rates — more than offsetting the impact of further credit easing.

Bernanke can claim a good deal of credit for hauling the United States from the brink of disaster. But he swung too swiftly from boldness to caution — putting the Fed on the sidelines. Barring an unexpected downswing, is now powerless to help accelerate recovery and bring down unemployment.

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