Doing Nothing At The Fed

The Federal Reserve combined an optimistic view of the economy with a set of decisions to leave most of the formal plans it has made over its last two meetings unchanged, according to the notes from the Federal Open Market Committee meeting in April. Optimism is subjective and tends to be even more so in hard economic times. The Fed’s core view on the economy as it stands is “that the pace of economic contraction is slowing.” The committee expressed little worry about deflation and almost none about inflation.

The FOMC is in a minority in its centrist position because there are inflation and deflation hawks among the most vocal economists. Rising interest rates and commodities prices combined with the hundreds of billions of dollars being pumped into the global economy will cause prices to soar once the recession blows itself out. The cost of money will rise over 15% as it did in the early 1970s.

On the other hand, deflation could set in for years, as it did in Japan in the 1990s, as GDP growth hugs a flat line and businesses are unable to raise prices. Unemployment stays high. Workers have no leverage to increase wages.
The Fed does not plan to combat inflation or deflation because it believes that neither is a threat.

The agency is also convinced that its forays into the market for US government debt, a plan under which it “will buy up to $300 billion of Treasury securities by autumn” is still a perfect balance for keeping interest rates at reasonable levels.

Finally, the note from the FOMC says it will “maintain the target range for the federal funds rate at 0 to 1/4 percent.”
The Fed will do nothing while the rest of the government is tilting from windmill to windmill in the hopes that it can keep housing prices from falling another 10% while it tries to keep unemployment from rising above 10%. Very few people think the stimulus package will save or create 3.5 million jobs because more jobs than that have already been lost, leaving the Administration to fill a six-foot hole with four feet of dirt.

The figures for the budget are also almost certainly wrong. Receipts are running tens of billions of dollars below forecasts because employment is worse than expected as are corporate profits. The Administration seems to be reluctant to admit that the government cannot tax what doesn’t exist.

All of these problems, most of them severe and intractable, devil the Congress and the Administration, but the Fed stands ready to do nothing other than hold a course set under circumstances many of which are months old. It is an odd way for the central bank to act when the recovery, if it exists at all, is so fragile.
The most serious error in the Fed’s actions is that it is unlikely to make a much more substantial investment in US government paper. The Treasury expects the global debt markets to absorb its borrowing needs even though more of those who are buying the debt are concerned that America will have to struggle to repay it. Absent a default, which is improbable, the solution to drawing new investors is a better yield. The debt service will become a horrendous problem if GDP does not begin growing rapidly again next year and then accelerates in the years immediately afterward.

The market may look back at the FOMC April meeting as one where inaction was the worst alternative even though it was tempting to let the healing economy have some time just for gentle recovery. The Fed did not elect to prophylactically increase its investment in US sovereign debt which would have been a show of good faith to other investors around the world. It did not target the fed funds rate at zero leaving out the high end of the range at .25%. Those things are troubling.

It is not unreasonable to expect that, in an emergency, operations within the federal government would not want to work in concert. That has never happened before and never will. The closest all of the financial agencies and Congress came to locking arms was when the credit system was at the edge of collapse late last year. As the appearance that the crisis had settled down grew, the parties went their separate ways. It could be a disaster if we find that they made this decision too early in the game.

Douglas A. McIntyre