Fed can’t fix broken economy, politics
The Federal Reserve’s decision to move to a kind of quantitative neutrality is a tacit admission that it, or rather that the United States, is in a political bind that makes a bold response to a deteriorating economy difficult.
Despite reams of evidence that conditions are worsening — much of it cited in the statement the Fed made as it left rates on hold — the U.S. central bank made only a token gesture; announcing that as mortgage-related debt it holds on its balance sheet comes to term and is repaid it will replace it with new, mostly long-term, Treasuries.
That keeps its quantitative easing policy essentially static, a strategy dubbed “quantitative neutrality” by Northern Trust economist Asha Bangalore.
So, given that key measures of inflation are trending towards zero, that businesses are reluctant to hire, that corporations and banks alike are sitting on cash and that the outlook for the recovery, if indeed we want to call it that, is dimming, why such a feeble response?
In the end monetary policy has to have a political consensus behind it, and there is arguably less of that now than at any time in my 20 years of following markets.
That is partly because during the collective fantasy of the Great Moderation we all believed that monetary policy could somehow be technocratic and above politics. Up to a point …
The Federal Reserve, for totally understandable reasons, often got out in front of the political process to make bold moves during the dark days early on. They did things, to be blunt, that went beyond their mandate. They paid off AIG’s contracts and, by buying up mortgage debt supported one sector of the economy over the others, poaching on Congress’ turf and setting themselves up for risks to their independence.
That is the significance of quantitative neutrality; the Fed is getting out of the capital allocation business and are, in so many words, saying to Congress and the White House that the next move is theirs.
That next move is not likely to be much of anything other than infighting ahead of November elections. Congress has passed $26 billion in aid to the states, a drop in the bucket and likely the last thing that gets through before the polls open. It may prove a disaster, but there simply isn’t consensus for much more, and so, much more may not arrive.
After the election, if the Democrats lose the house as many expect, the outlook for meaningful further stimulus is even dimmer.
In many ways, this mirrors Japan’s lost decade, except in typically speeded-up American style. Japan was unable to agree politically to keep the stimulus coming year after year, easing up in the late 1990s. Many believe that this set the stage for another lapse into deflation and recession, but of course no one really knows.
QE II or Titanic II?
Is it the fed’s job to do the heavy lifting when the political process isn’t “working”? Many in financial markets seem to think so, but the Fed does not exist to cut the Gordian knot of politics.
Might the Federal Reserve embark on Quantitative Easing II without strong political support? Maybe, but not likely, and what is clear is that strong political support for much of anything is not likely to happen in the next several months, almost regardless of the data or the evolution of the economy.
There are too many people who, right or wrong, are highly suspicious of all accommodative policies, fiscal or monetary.
That may be good policy or it may be bad, but the anger about government spending and policy is real, and the United States is heading into November elections in which many who supported the massive stimulus will be returned to the world of lobbying, consulting and just possibly answering their own mail.
My guess is that inaction is bad policy and that the United States needs more stimulus but this is a debatable point.
A recent ECB working paper showed that stimulative government spending in Europe is producing diminishing returns compared to the 1980s, a phenomenon it attributed to rising debt levels. This may be true too in the United States, though perhaps to a lesser extent.
What is very likely true is that the United States will discover that its economic fix is very serious and that its own political process will be unable to muster much of a response.
It may be that only a market panic brings the parties together, setting the stage for strong government action, and with it a decisive and bold Fed.
That panic, sadly, may be just what we get, as investors realize, as perhaps they were during Wednesday’s market sell-off, that the Adults can’t agree.
Nothing brings consensus as rapidly as an emergency.