Tuesday, April 27, 2010

The Fed Can't get No Satisfaction

There is a blurb this morning on Bloomberg.com titled “Fed ‘Squeezed’ by Recovery Momentum May Affirm Low-Rate Pledge.” The experts are predicting that the Fed will not change its language about policy and will continue to guarantee virtually zero interest rates for an extended period of time. They note that while there has been much positive economic news and financial markets are awaiting some sign the Fed will begin to worry about inflation, the Fed is compelled to continue to focus on high unemployment, especially since inflation continues to be tame.

That’s the story. And it underscores a worry that there may not be a clear signal for when the Fed really does begin to suck out all that liquidity that threatens economic stability. Let’s face it, the economy grew at a strong pace in the latter half of 2009 and appears to be growing at 3+% in 2010:Q1. Is a zero interest rate compatible with US economic growth averaging 4% or more for three-quarters of a year? If you answer yes, then what happens if the economy grows at a mere 3% in 2010:Q2? Then we will have had a full year with real GDP averaging almost 4%. Is that enough to change policy? What if the unemployment rate is still high in July? Will these same experts be ready to prod the Fed away from zero interest rates? I think you are starting to see the policy risk here.

Simmer down Larry. So what if the Fed is a bit late in coming to the inflation party? Why should we care so much about inflation when so many people are unemployed? The ANSWER is that we care about future inflation MOSTLY because it will lead to a cycle in which unemployment gets WORSE. We care about inflation BECAUSE we care about unemployment. When do you start your diet – only after you have nothing left to wear but a potato sack? I hope not! It might be better to start just before your current jeans are so tight that you have to unbutton them to breathe now and then. Anyway, let me keep this short and summarize the issue:

First, there will be no AHA time when everyone agrees it is time to start tightening. There are always expects who see softness or the next recession around the corner. Please Mom, my pants are supposed to look like that.

Second, tightening money growth will mean higher interest rates and will cause consternation among many groups. It will take a very tough Fed to deal with the ugliness that arises when a phase of tightening begins – even though this phase largely will be meant to remove a ton of excess liquidity. Notice that raising the Fed Funds rate to 1% would be considered a big jump from the current 0.25% -- but also notice that a 1% Fed Funds Rate is VERY low in historical terms. Please Mom, let me have one more piece of cake!

Third, the policy change will probably come later rather than sooner and will lead to higher unemployment than necessary because it will have to deal with rising inflationary expectations and higher prices for commodities. Geez Mom, this diet is making me dizzy.

In the US we have an independent Fed with a newly reappointed Chair. The Fed has a choice. It can play to popular opinion a while longer and risk much higher inflation AND unemployment. Or it can move quickly (and gradually) to reassure domestic and international publics that the best way to keep a strong stable economy with low unemployment is through price stability. So which ways is it going to be? I guess we will learn more tomorrow.


  1. I think tightening may be politically timed, with the majority of it coming after Nov 2010. Note that TIPS were trading at negative yeilds to the US treasury in March (http://www.bloomberg.com/apps/news?pid=20601103&sid=aIbnAuYWv3A0)(I think this article refers to seasoned TIPS). Bloomberg reports that new issue TIPs today are forecasting about 2-3% inflation over 5-10 years. So the market itself is very uncertain about inflation..

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  3. I removed my own comment above because I had a bad typo and it won't let me edit my own comments! So here goes again...

    Hmmm and here I thought the Fed was independent? :-)

    I am wondering what the market thinks about the impacts of government deficits and the monetary overhang on inflation? What is behind inflation forecasts of 2-3%?

    I looked at CBO long-term forecasts for inflation -- mostly 2% or less. Despite government deficits, it appears that these forecasters see excess capacity declining slowly and slow growth keeping a lid on inflation. Interesting...

  4. The Euro-zone drama will provide a convenient excuse for the Fed to continue to leave rates low.

    Plus, let's not discount the influence of the "inflation tax" to help the gov't pay current debts with cheaper future dollars.