Does the Fed Need to Ease Even More?

Five months ago, I posed the question: "Has the Fed eased too much?" Basically, I argued that the Fed, having checked deflation, had not eased too much. Now, the question being debated in many quarters is: "Does the Fed need to ease more?" Last weekend at the Fed's annual Jackson Hole meeting, Chairman Bernanke acknowledged "that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting" while the FOMC expected inflation to settle at a level at or below the 2 percent that is acceptable to the FOMC. Chairman Bernanke also expressed the hope that growth would pick up in coming quarters.

Bernanke's speech contained two other important elements. First, while not offering any additional specifics about "tools that could be used to provide additional monetary stimulus," he did acknowledge that the FOMC meeting in September had been expanded to a two-day session to allow for discussion of the Fed's policy options. Markets ultimately decided after the speech to take this as a signal that further stimulus was coming, apparently without reflecting very much on the paucity of alternative measures the Fed might undertake to provide additional stimulus, especially in view of the disappointing results that have followed QE-2.

Chairman Bernanke also challenged Congress and the President not to repeat the deficit and debt ceiling debate fiasco of last July. Specifically, he suggested that "the country would be well-served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well...."

The overall impression from Bernanke's Jackson Hole presentation this year was not to expect too much from the Fed in the way of additional support for economic growth. Rather, an orderly process to reduce future budget deficits while lowering marginal tax rates was something he hoped the Congress would be doing. For its part, the Fed's promise at its mid-August FOMC meeting to keep the short-term rates virtually at zero for the next two years is about the best it can do.

The day after Chairman Bernanke spoke, Christine Lagarde, the new managing-director of the International Monetary Fund, broke the unwritten rule at Jackson Hole not to use alarmist phrases to describe the world's economic problems. Rather, she declared in her address that the world economy is at a "dangerous new phase" and spoke of a need for "urgent recapitalization" of European bank balance sheets. She added that "risks have been aggravated further by deterioration in confidence and a growing sense that policy makers did not have the conviction or simply are not willing to take the decisions that are needed." Hardly the language one would link to the idea that the Fed -- or the ECB -- has eased too much.

Notwithstanding IMF Director Lagarde's call to action, the basic problem facing the global economy in 2011 is an absence of obvious policy solutions to the rapid slowdown of real economies in the U.S. and Europe and to the negative consequences flowing from those slowdowns to financial markets. As it had done in 2008, the European Central Bank actually raised rates early in the summer of 2011, sending the wrong signal at a time when the global economic slowdown threatened. The resources provided in the recent agreements to support Greece and the other distressed small European economies entailed substantial fiscal austerity as a condition for transfers from the IMF and the shrinking group of other European economies still able to provide loans. Later, in an abrupt reversal of its feint towards tightening, the ECB became an outright buyer of Spanish and Italian bonds in August.

In the United States after a heavily criticized second round of quantitative easing by the Fed, and an ignored/discredited round of fiscal stimulus enacted in 2010, the U.S. economy is close to stall speed at a 0.8 percent growth rate during the first half of 2011, and may have already entered recession. As fiscal stimulus packages unwind, fiscal drag may rise in the United States to a level equivalent to about 1.5 percentage points of GDP early in 2012.

There are no clear and easy solutions to the many problems facing the U.S. and European economies. In the United States, we need, as we have all along, fundamental tax reform with lower marginal tax rates financed by closure of arbitrary tax loopholes. The Fed still needs to guard against a return of deflation. We need lower growth of spending on entitlements once the current financial crisis is over. And perhaps most fundamentally, we need leadership in both political parties that rises above confidence-sapping partisan bickering and provides policy measures best suited to curtailing our current crisis of confidence.

Europe needs to abandon the illusion, articulated once again by ECB President Trichet at the Jackson Hole meeting, of a single currency area that includes such disparate economies as Germany and Greece. That impossible dream has now left Germany virtually the only country that can survive Europe's single currency illusion. The result has been to impose overly stringent policies on the rest of Europe that have come to threaten the solvency of the European banking system while slowing even German growth.