The Fed Outlook: No Good Choices
September 13, 2010
In his semiannual monetary policy testimony to Congress in July, Federal Reserve Chairman Ben Bernanke said that the Fed “remains prepared to take further policy actions as needed to foster a return to full utilization of our nation's productive potential in a context of price stability.” In his Jackson Hole speech (August 27), he outlined possible steps the Fed could take, including expanding its holdings of longer-term securities, but cautioned that “the expected benefits of additional stimulus from further expanding the Fed's balance sheet would have to be weighed against potential risks and costs.” The Fed recognizes that recent economic data have been disappointing. However, according to Bernanke, “the preconditions for a pickup in growth in 2011 appear to remain in place.”
The Fed sees economic support from “very accommodative” monetary policy and improved financial conditions. Banks have improved their balance sheets and are more willing to lend. Consumers have reduced debt and built up savings, returning wealth-to-income rations near to their historical norms. Strong corporate balance sheets and low costs of financing should continue to support business spending on equipment and software. On the negative side, residential and commercial real estate are likely to remain weak, state and local government budgets remain under significant pressure, and federal fiscal stimulus is set to fade. On balance, economic growth is expected to be subpar in the near term, but still positive.
Core inflation has trended lower through the first half of the year, but may be stabilizing at a low level. An economy operating with considerable excess capacity will tend to see downward pressure on inflation, but well-anchored inflation expectations should prevent inflation from falling a lot more (say, into negative territory). Inflation expectations have begun to edge down and they should continue to fall as long as inflation remains lower than expected. However, unless the economy stumbles more substantially in the near term (not likely) or fails to pick up as anticipated in 2011, then the prospects for outright deflation (a sustained rate of decline in the overall price level) are relatively remote.
Back in 2002, then-Governor Bernanke recommended preventative action against the possibility of deflation. The Fed should act swiftly and forcefully to prevent deflation. So why isn’t it doing more now? The main reason is that the Fed has already done a lot in terms of credit easing and there are perceived risks in doing more. Purchases of long-term securities made sense when the economy and financial conditions were under severe duress, but may be much less effective when conditions are more normal. Moreover, a further increase in the size of the Fed’s balance sheet could undermine public confidence in the Fed’s ability to exit such a policy later on.
There is also an important side debate about how much the economy can improve over the near term. Some economists have argued that the increase in unemployment is structural, the result of a mismatch between the skills of those laid off and the skills that are needed in the “new” economy. Other economists argue that the rise in unemployment is cyclical, a consequence of a weak economy in general. Why not both? There is some evidence supporting both views.
The Beveridge curve relates job vacancies and the unemployment rate. The recent trend has broken above the expected pattern, consistent with at least some skill mismatching. The Fed’s recent Beige Book noted upward wage pressures “in a narrow set of sectors experiencing a mismatch between job requirements and applicant skills.” In addition, the housing debacle has likely led to a decrease in labor mobility.
Even if the labor market weakness is mostly cyclical, there’s a view that the chief factor in the economic recovery is time. That may explain the Fed’s complacency in the face of what is expected to be a prolonged period of elevated employment.
(c) Raymond James