By Desmond Lachman Saturday, August 14, 2010
Filed under: Economic Policy, Boardroom, Government & Politics
On reading the Federal Open Market Committee’s (FOMC) latest monetary policy statement, one cannot help but get the sinking feeling that yet again the Federal Reserve is behind the policy curve. Since much in the same way as the Fed was very late in recognizing the onset and then the depth of 2008-2009’s Great Economic Recession, so too today the Fed is downplaying the real risk of a double-dip economic recession and of the associated threat of Japanese-style deflation. And, much as the Fed was painfully slow in responding to the onset of the 2008-2009 recession, so too today is the Fed being far too tentative in its policy response to the U.S. economy’s present deflation risk.
The FOMC’s August 10 meeting took place against the backdrop of a slew of disappointing economic data. From weak housing market data to discouraging employment numbers, and from swooning consumer confidence indicators to weak bank lending figures, one could not reasonably entertain doubt that the modest U.S. economic recovery was quickly running out of steam. Yet the Fed was rather grudging in acknowledging that “the pace of economic recovery is likely to be more modest in the near term than had been anticipated.” Ever hopeful, the Fed also considered that somehow the economy would soon make “a gradual return to higher levels of resource utilization.”
An abrupt slowing in an economy is not welcome news at the best of times. However, these are hardly the best of times. Headline unemployment remains stuck at above 9.5 percent, while, including discouraged workers and part-time workers who cannot find full-time employment, the unemployment rate is closer to a record 17 percent. It is little wonder then that consumer sentiment remains subdued, wages are falling, and the housing market fails to respond to the lowest long-term mortgage rates in the postwar period.
The FOMC’s recent meeting also took place against the backdrop of a marked deceleration in inflation, to very low levels. In response to the unusually large gaps presently characterizing both the U.S. output and labor markets, over the past six months core consumer price inflation has declined to an annualized rate of 0.6 percent. One would have thought that such a low inflation rate would have been raising red flags at the Fed about the dangers of deflation, particularly at a time when there is little prospect of any narrowing in the large deflationary gaps presently characterizing the U.S. output and labor markets.
In setting monetary policy, the Federal Reserve is supposed to be more forward- than backward-looking. Had the Fed indeed been more forward-looking at its August 10 meeting, it would have mainly focused on one key question. How is the U.S. economy likely to be impacted in the remainder of this year by the rapid fading of the Obama fiscal stimulus package and by the inventory accumulation cycle running its course? At present, that question would seem to be all the more pertinent since, between them, the fiscal stimulus package and the inventory cycle have accounted for almost the entirety of U.S. economic growth over the past three quarters.
A forward-looking Fed would also have been mindful of the array of strong headwinds that the U.S. economy presently confronts, which could very well tip the economy back into recession. Amongst the most important of these headwinds is the very high unemployment rate that is all too likely to continue constraining the wage growth needed for a meaningful revival in household consumption. In addition, there is the risk that the ongoing foreclosure crisis could lead to a further 5 percent to 10 percent drop in U.S. home prices, that U.S. banks will continue to reduce lending, and that budget-constrained states and local governments will cut back on spending.
Seemingly oblivious to these risks, the Fed refrained from a prompt resumption of the quantitative easing policy that it had ended in March 2010 and it rejected exercising the option of announcing an explicit inflation target. Instead, the FOMC confined itself to repeating its intention to keep the federal funds rates at “exceptionally low levels for an extended period,” as well as to committing itself to use the proceeds of the maturing securities that it holds to buy long-dated U.S. Treasury securities.
The Fed’s apparent policy timidity in the face of a rising deflation risk is to be regretted. This is not simply because monetary policy operates with long lags, during which time a debilitating deflation can take hold. Rather, it is because, with the room for further U.S. fiscal policy easing having now been exhausted by the extremely poor state of the U.S. public finances, monetary policy is the only game left in town. And sadly, it looks like Fed Chairman Ben Bernanke, the man in charge of that policy, is again in the process of dropping the ball.
Desmond Lachman is a resident fellow at the American Enterprise Institute.
Image by Rob Green/Bergman Group.
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