Tag Archives: Federal Reserve

BackInTheBlackBlog is on vacation this week, but let me offer just some brief reactions to two pieces of news of last week.

You may have seen repeated stories about Federal Reserve Governors and regional bank presidents doing the rounds to speak about monetary policy.  I attended a speech by Jerome Powell, one of the most recently appointed Governors.  I worked with Jay on his efforts to explain the dangers of playing a game of chicken over the statutory debt limit, and can testify that he is knowledgeable, skilled and impartial.  He will be an excellent Governor for these trying times.  But his remarks this week illustrate just how difficult the Fed’s job will be.

The speaking rush by the Fed comes because of what Jay described as an out-of-scale market reaction to Chairman Bernanke’s press conference after the most recent Federal Open Market Committee (FOMC) meeting.  At that meeting, the members downgraded their individual near-term economic forecasts, but upgraded their forecasts for a few quarters down the road – citing evidence that the economic recovery has grown firmer roots.  On the basis of those stronger expectations, Chairman Bernanke spoke in his press conference of his anticipation that the Fed would begin to taper off its current monthly purchases of longer-term securities in the open market as of September of this year, and would reach zero purchases by the middle of next year.

Reacting to this discussion, the financial markets went bonkers, with large one-week increases in long-term Treasury and mortgage interest rates.  This raised the prospect of an adverse near-instantaneous feedback loop from housing-is-recovering to OMG-the-Fed-is-going-to-tighten to sell-bonds to higher-mortgage-rates to housing-plunges.  It was a fear of such a market reaction that sent Fed Governors and Bank Presidents rushing to the microphones and television cameras.

Jay’s message – beyond characterizing the market reaction as out-of-scale to Chairman Bernanke’s signal – was to emphasize the magic words, “data-driven.”  Jay made clear that Chairman Bernanke intended to describe a scenario that would play out if the central tendency of the Governors’ forecasts materialized; if the economy turned out softer, the Fed would delay its tapering off of the asset purchases.

That is of course the right policy process.  But here is the rub:  We are in a truly unprecedented situation; and there is a very fine line between being “data-driven” and “driving in the rear-view mirror.”  Chairman Bernanke and the FOMC decided to send their initial signal on the basis of a forecast.  Because the data lag actual events, even the FOMC’s final decision necessarily will be made substantially on the basis of a forecast of the future – else it could be too late.  And because the situation is unprecedented – with the Fed sending pressure through previously unexplored channels to stimulate economic activity – the reactions of the market to further unprecedented steps, like withdrawing quantitative easing, are unpredictable and could easily be just as excessive as were the reactions to Chairman Bernanke’s press conference.  So to avoid acting too late, and therefore quite possibly causing or exaggerating bubbles in the economy or setting off an accelerating inflation, the FOMC will have to act on a forecast – just as they spoke on a forecast through Chairman Bernanke after their recent meeting.

The FOMC clearly has thought this unprecedented situation through about as well as can be done.  But there should be no doubt that they face a daunting task.  Their decisions necessarily will depend on judgment calls about an unknowable future.

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I’ve been saying for several years that the best person to manage our way out of the current economic doldrums would be George Balanchine (if only he weren’t dead) – because this will need to be the most carefully choreographed dance of monetary and fiscal policy in all history.  The Federal Reserve will at some point need to raise interest rates that currently are on the floor (“at the zero bound,” in econ speak) and draw down a balance sheet that is orders of magnitude greater than its normal size, to head off inflation – all in a shaky economy nestled in a shaky world economy.  Meanwhile, the fiscal policymakers will have to head off a mounting debt by slashing a far-oversized budget deficit, which is driven by complex structural problems with their own powerful political self-defense mechanisms – all the while avoiding crunching that same vulnerable economy, and somehow acting in harmony with the aforementioned independent Federal Reserve.  It is a situation only an academic economist could love:  It offers plenty of ivy-covered reward for writing theoretical papers which will never be tested in practice, and so have no real-world consequences.

And that is the good news.  A recent more-practical (but still plenty wonkish) paper by two Federal Reserve economists, Christopher J. Erceg and Andrew T. Levin, explains that today’s labor market is not only painful, but also puzzling to policymakers.  It identifies yet another unprecedented challenge that is layered upon all the others to make the path back to Normal, wherever that is (unfortunately not the town that is readily visible on the map of Illinois), even more tortuous.

The Erceg and Levin paper already has gotten plenty of press (for example, see a New York Times reference here), but is worth your attention if you have not seen a close discussion.

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