The Fed Stays The Course

by: Robert Kuttner

Financial markets rallied when the Federal Reserve defied the rumor-mongers and resolved to continue its program of keeping interest rates very low until the unemployment rate improves. There was only one dissenting vote on the Fed’s policy-setting open market committee.

What’s going on here? Ever since the run-up to the collapse of 2008, what’s good for Wall Street hasn’t exactly been good for the rest of the economy. Are these ultra-low interest rates just pumping up more financial bubbles, as critics fear? Or does a still weak economy need this form of stimulus?

Think of it this way. There are risks to continuing a policy of very easy money, but premature tightening would be even worse.

The markets and the pundits got this one wrong because the hawks in the Fed system had been leaking rumors that they had the votes and that the Fed would soon be “tapering” (pulling back) its program of $85 billion-a-month in bond purchases. Chairman Ben Bernanke, to appease the hawks, lent credence to this belief in some of his recent statements. Markets began bidding up interest rates in anticipate of the Fed’s tightening money.

But the economy did not cooperate. Growth is still sluggish. Wages are flat on average, and declining for most Americans. Though the nominal unemployment rate is coming down, the main reason is that more people are giving up looking for nonexistent jobs and quitting the labor force. The rate of adult labor-force participation is at a five-decade low.

The rumors of a shift in Fed policy served to add to the depressive economic drag because they raised interest rates on mortgages and consumer loans. So the Fed decided to stay the course.

The trouble with the course is not that it risks inflation or even that it promotes bubbles, which can be contained by good regulatory policy. The problem is that ultra-cheap money is a second-best remedy.

A first-best, as the Fed itself declared in its statement, would be for a more expansive fiscal policy—less obsession with deficit reduction and more public spending. With fiscal policy contributing to a sluggish recovery, monetary policy is all we have, and thank heavens the Fed is in the hands of people who appreciate that.

The likelihood that Janet Yellen will chair the Fed increases the chances that monetary stimulus will continue, and that Yellen will be an even more forceful critic of depressive budgetary policy. Had Larry Summers gotten the job, the Fed would likely have tightened much sooner.

However, as some in the Fed system recognize, the massive program of bond purchases to force down interest rates is a second-best in another sense. Most of that money is staying right on Wall Street, to be invested in Treasury securities or speculative trading plays. It isn’t getting out to the real economy to provide relief to underwater homeowners or small businesses that are deemed just a bit too risky for bankers to lend to.

An even more effective monetary strategy would have the Fed pump money directly into the real economy by purchasing bonds to back infrastructure, small business, and mortgage refinancing. This idea has been discussed—gingerly—at the Bernanke Fed, and rejected as too radical. Let’s see whether a Yellen Fed will take it more seriously.