Opinion

James Saft

Whacking the economy with a wrench: James Saft

May 22, 2014

May 22 (Reuters) – Did you ever get to the point when trying
unsuccessfully to fix something you just start whacking it with
a wrench?

I am getting the feeling that the Federal Reserve is
approaching that point with the economy.

Fed officials have recently outlined some unconventional
policy options that may indicate desperation, bravado or even,
perhaps, a backward kind of genius.

Two main points stand out: that the Fed might want to
tolerate inflation above its 2 percent target for a period, and
that it may wish to have an almost permanent portfolio of bonds
on its balance sheet

Taken together, these ideas underline the fragility and
weakness of the recovery and indicate that a return to normal
may be more of a hope than a hard target.

In some ways this is all understandable. Here we are, the
better part of a decade into the financial follies and despite
ultra low rates and wave upon wave of special measures,
inflation is too low and employment far too weak.

Not only is this puzzling – or at least puzzling based on
much of what Fed officials believed before the crisis – we are
now reaching the point in the cycle where it is reasonable to
wonder what the central bank might do if we entered a new
downturn.

The most important idea – that the Fed might signal its
willingness to tolerate above-target inflation – has recently
been enunciated in slightly different forms by both Bill Dudley,
head of the New York Fed, and the far more dovish Federal
Reserve Bank of Minneapolis President Narayana Kocherlakota.

Dudley, in a speech earlier this week, argued simply that
the 2 percent figure was a target, not a ceiling, and that as we
had spent considerable time below it we might be expected to go
above it as well.

Kocherlakota, without explicitly endorsing the idea, said
that such “price level targeting,” in essence a period of
catch-up inflation above the 2 percent target, “has the
potential to affect the near-term speed of the economy’s
recovery.”

The idea is that if the Fed sends such a strong signal,
businesses will react by investing and hiring in anticipation of
inflation and demand to come.

This might be achieved by targeting 2.5 percent over a
five-year period, he said. It well might, but as ever, the worry
is that the Fed loses credibility as an inflation fighter (yes,
I hear you saying “what inflation?”).

In some senses, that’s exactly how it would work. If the
economy, mired in too much debt, is unable to create inflation,
the Fed may have to do it by giving a convincing impression of
having taken leave of its senses.

The same crazy logic worked for the Swiss National Bank, in
another context, when it essentially pledged to be the buyer of
last resort of the euro in order to hammer the Swiss franc
lower.

WANTED: PORTFOLIO MANAGER, POSITION PERMANENT

The other idea, that the Fed may want to continue
re-investing the maturing proceeds of bonds held on its balance
sheet even after the taper is over and it is buying no new
bonds, is also radical in its own way.

Dudley too mentioned this idea in his speech, arguing that
it may be better to wait until after raising the policy rate
before halting re-investments. The idea is to gain some room on
interest rates sooner, allowing the Fed some flexibility. It
also would simplify communications, he argued.

Boston Fed President Eric Rosengren made an allied but
different argument in an interview with the Wall Street Journal,
but noted instead that a balance sheet might be useful in
maintaining financial stability. That almost implies a
permanently large balance sheet, because after all, financial
stability is a permanent issue.

I am not actually arguing against this, as any thoughtful
person should admit they are simply not sure about how advisable
and dangerous it might be to foment inflation by saying you will
put up with what usually is considered too much of it.

Having said that, nothing else has worked yet.

Even beyond rescuing the unemployed from their very real
plight, one side benefit of inflation would be to lower the very
high and quite possibly crushing burden of debt.

An unfortunate side effect (some might argue, object) of the
way in which the financial crisis was fought – rescuing the
banks and keeping homeowners on the hook – was that not very
much debt was destroyed, despite there being so much debt as to
be unsustainable.

Those debts must be defaulted or inflated away, as they
impede the growth needed for repayment.

The unspoken choice might be between default in a new crisis
or inflation – hopefully controlled – before that can happen.

(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

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