The Federal Reserve recognized that the economic recovery has slowed in recent months, according to the FOMC statement issued yesterday. The central bank also said that inflation has "trended lower in recent quarters" and that pricing pressures are likely to remain "subdued for some time." What will the Fed do to a) help keep deflationary pressures from gaining strength and b) bolster growth? Two things, according to the FOMC announcement. One, it will keep Fed funds at a zero-to-25-basis-point target rate for an "extended period." Two, it will invest the proceeds from its bloated mortgage and agency debt portfolio in longer-term Treasuries to help keep long rates low. The question, of course, is whether this will suffice to offset the downshift in economic momentum of recent months? No one really knows, but the argument that this is enough looks thin.
There are additional quantitative easing steps the Fed could embrace, including a more aggressive effort to lower long rates by "printing money" and buying long-dated Treasuries. It could also stop paying interest on bank reserves, or even charge banks a fee to keep reserves at the Fed. It's not clear how effective such actions would be, but those are tools at the central bank's disposal and it's premature to argue that they're ineffective.
In any case, the stock market certainly wasn't impressed with the Fed's statement yesterday. Equity investors initial reaction was more or less a yawn after reading the FOMC press release. The S&P 500 slipped by around 0.5% on Tuesday. By Scott Sumner's pre-emptive standard for what the Fed needed to accomplish, the crowd's early reaction was a disappointment. "In my view a stock market rise of 2% to 4% would be an indication that the Fed had done something significant, making a double dip recession considerably less likely," Sumner wrote a few days back. We didn't get anywhere near that in terms of an initial vote of confidence in stocks. Strike one.
What about changes in inflation expectations? That's a little better, but just barely. On Monday, the market's 10-year inflation outlook was 1.82%, based on the yield spread between the nominal and inflation-indexed 10-year Notes. A day later, after the Fed had spoken, the inflation outlook was higher by a thin 2 basis points, rising to 1.84%. As the chart below reminds, that's a disappointment too, given the decline in recent months.
Of course, not everyone's worried about deflation or the threat that the tenuous recovery will continue to weaken. There are still some who worry that inflation is a real and present danger now, today--and that the economy is poised to pick up a head of steam. Indeed, some who subscribe to this outlook are voting members of the FOMC, and so one could argue that yesterday's tepid response by the central bank to lean more heavily in favor of growth was a political compromise of sorts. A committee trying to design a horse ends up with a mule.
Maybe the problem is that the published economic numbers that I'm reading hide some emerging trend that favors expansion. Perhaps there are those on the FOMC who see what I can't: an imminent and robust rebound in the broad trend. If so, I wish they'd share their analysis in detail with the rest of us.
Unfortunately, the numbers, at best, speak of mediocrity in the trend, at least the numbers that are publicly available. At worst, it appears that the trend is deteriorating. As such, it doesn't take a great leap of faith to think that inflation and economic activity generally may continue to slow in the weeks and months ahead. Is this destiny? No, not yet, but neither is it beyond the pale.
If ever there was a case for more quantitative easing in an effort to elevate aggregate demand, the time is now. If not now, when? Under what conditions? Isn't the data sufficiently discouraging? Isn't the outlook convincingly soft? Or should we wait for even more discouraging numbers? Then again, if you're expecting salvation in the next round of numbers, the case for doing nothing, or even tightening, looks stronger.
Yes, there's a risk that the Fed may be laying the groundwork for higher inflation if it moves to the next level of monetary stimulus. Of course, that's the point, isn't it? We want higher inflation for the near-term future; we want higher prices, including a rise in nominal GDP. On that, we can all agree (maybe). The debate is over whether this state of affairs is fate via the current level of monetary policy. Or does the trend need additional help?
The full compliment of economic reports argues for the latter, or so it appears to this observer. Unfortunately, the Fed's degree of assistance is open to some debate. The current conditions are relativley unprecedented, and so to some extent we're knee-deep in a grand experiment.
But the numbers looking backward don't lie. For instance, one measure of the money supply is contracting (as defined by the annual percentage change in MZM money stock, calculated as M2 less small-denomination time deposits plus institutional money funds). As the second chart below shows, MZM shrunk by 2% in late July vs. a year earlier. Given the current economic climate, this trend looks inappropriate by more than a trivial amount.
What's the risk of trying to go to the next level of monetary stimulus? Unleashing runaway inflation in the years ahead is the worst-case scenario. Of course, the Fed knows how to control inflation by mopping up excess liquidity, assuming it has the discipline to act in a timely manner. That's not easy, but central banks weren't invented to be country clubs.
Then again, given the central bank's actions of late, we shouldn't assume that Bernanke and company has the stomach for a monetary battle on either the inflationary or deflationary fronts. It's always easier to split the difference and stand on the middle ground. But sometimes monetary policy requires something more. Arguably, this is one of those times.
This post has been republished from James Picerno's blog, The Capital Spectator.
Labels: Federal Reserve