Weakened Fed mulls threats, promises

October 19, 2010

As any schoolteacher knows but the Federal Reserve will soon learn, threats and promises are the tools of the weak.

Trapped by interest rates that cannot sink below zero, the Fed, it is becoming clear, is not just preparing to engage in a massive new purchase of securities, or QE2, but is also considering a new communication policy it hopes will convince people that inflation, if not recovery, is just around the corner.

Investors expect a second round of ‘quantitative easing,’ or QE2, will take the form of increased purchases of Treasury debt aimed at keeping long-term rates low and encouraging consumers and businesses to go out and spend.

“There are special circumstances when price-level targeting would be a helpful complement to our current and prospective strategies in the U.S.,” Chicago Fed President Charles Evans said on Saturday.

“Clearly communicating an expected path for prices would help guide the public’s understanding of the Fed’s intentions while we carry a large balance sheet and promise continued low interest rates for an extended period.”

Evans proposes that the Fed, in response to a a period where inflation fails to rise by the desired amount, promises, or threatens, to create conditions that would take inflation above their target for a period in the future. The distinction here is that the Fed will target price levels, their absolute amounts, rather than inflation, the rate of change. That means that periods of sub-target inflation imply even looser policy for longer in order to hit the promised level of prices.

This is a radical and risky departure for the Fed, so it is worth looking in detail at how it might work and how it might fail.

First, as Evans explains, the Fed must recognize that it is in an extraordinary spot and announce that it is going to enter into a new, extraordinary policy. Next you have to tell people when it was you fell into the liquidity trap and what your promised level of inflation is. Evans favors December 2007 and 2 percent, respectively. That is supposed to give the public the idea of how far behind we are and just how much inflation the Fed is promising to unleash.

Core U.S. inflation was just 0.8 percent in the 12 months through September, the smallest rise since 1961.

Third is regular communication by the Fed that it means business and will use its tools, be they QE2 or others, to hit its objectives. The final step is to clearly define how you will know you have been successful, and Evans argues that this means not just hitting the price level targets but sticking with them for several months.

BIRTHRIGHTS AND BOWLS OF SOUP

What all of this means, in short, is that the Fed in current circumstances is weak, that its normal tools of managing inflation and employment are not working well and so, not being confident that it can simply act and get the results it wants it has to try to get a multiplier on its actions through promises.

It is interesting to note that this is part of a long, slow process towards more transparency at the Fed but that that very transparency, as for the Wizard of Oz, has meant a reduction in power. It was only in 1994 that the Fed began announcing its target interest rate. Before that an army of Fed watchers would scramble in the aftermath of a policy meeting to work out what rate the Fed’s open market operations were enacting.

Fast forward to the current crisis when interest rate policy no longer works and the Fed must resort to printing money and buying bonds, a policy so effective that the U.S. central bank must now try to amplify even that.

As it is with threats and promises in the classroom, so it is with the markets; this new policy may fail either if the market believes the Fed or if it doesn’t. It is especially worrying that the market, particularly the currency market, could decide that the Fed will be unable to dismount from its tiger, that it will find it hard politically to tighten policy in the face of high unemployment even if its price level targets are met.

The other big question is why promise to raise price levels, why not just print so much money and buy so many bonds or other assets that prices do rise?

Here again we enter into politics and how the Fed, in taking extraordinary steps to avoid a depression, has weakened its independence.

The United States is going to borrow about $1.5 trillion in the coming year, while the market currently believes that the Fed is going to buy about $1 trillion. And yet there is no inflation. This implies that $1 trillion is not enough. But if the Fed prints money equal to all of the U.S.’s borrowing they will be open to claims that they are monetizing the debt, an accusation that could undermine the very confidence the Fed wishes to trade upon.

The truth may be that optimal policy may imply very, very sub-optimal results.

3 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

At some point, preferably sooner rather than later, the increasingly desperate actions being contemplated by the Fed will be seen for what they are – an attempt to mitigate the damage done by the fiscal policy / taxation non-policy / re-regulation policy emerging from the White House and the current administration. Bad, in this instance, egregious, fiscal policy can only be countered by the voters making a change, preferably at the top but that time is not yet due, but change certainly in the lower levels of government. America really can’t afford much more of Mr. Obama’s remarkable incompetence, and Mr. Bernanke should cease making a sick joke out of the Fed. Printing money, indeed, the province of banana republics.

Posted by Gotthardbahn | Report as abusive

I don’t understand. We already have inflation, given that health care, food and energy costs continue to rise. Oil never really came back down, did it. During this “promised inflation”, what will happen to these already-rising costs? My opinion is, they will gallop on ahead and steal all the money. Again. Far better than printing all this money is eliminating the structural problems that presently are keeping money out of the hands of those who spend it- ie the consumers.

Posted by BFMorris | Report as abusive

To date, all of the Fed’s actions have had a negative effect on the economy. It’s paying of banks to borrow its funny money created an excessive availability of speculative money that precipitated the housing crisis, their efforts at “economic recovery” were ineffective and damaging to the point of being laughable, etc.

Why would anyone in their right mind think that this new brain-storm is going to solve any of the country’s economic problems? To the contrary, the vast majority of respected economists think that a whole new set of economic problems will be created. Some examples: Almost all (if not all) of the professional economists that contribute to the MarketOracleUK website. At the G-20 meeting, Bernanke was severely criticized and received no support from anyone,

Bernanke is the king of unintended consequences. Let’s see if he can get out of the responsibility for the results of his coming fiasco!

Posted by gAnton | Report as abusive