What Are the Fed's Policy Options?

by: Cullen Roche

A recent Goldman Sachs note discussed the policy options available at this juncture in the economic “recovery”. They said (via ZeroHedge):

“5. What would be the policy response to a sustained slowdown? We do not expect much. On the fiscal side, we currently assume fiscal restraint of about 1% of GDP in 2012. This is based on the notion that Congress will implement modest discretionary spending cuts, and that the remaining provisions of the 2009 stimulus package as well as part of the late-2010 bipartisan fiscal deal are left to expire. The most stimulative outcome we can imagine is that all of the 2010 provisions—the payroll tax cut, the unemployment benefits, and the depreciation bonus—are extended, but even that assumption would leave some restraint. And it is also possible that the restraint will be larger than our baseline assumption, via deeper discretionary spending cuts and/or a full expiration of the 2010 provisions. Like it or not, fiscal stimulus no longer has strong advocates in Washington, so its time has very likely passed at this point.

6. This puts the onus on monetary policy. And sure enough, markets that not long ago were predicting rate hikes are now starting to debate QE3. But we believe that the Fed’s “zone of inactivity” is much wider than these wild swings might suggest. The hurdle for rate hikes is high, and we feel good about our long-standing view that the funds rate will remain at its current near-zero level until 2013. But the hurdle for QE3 is also high, and indeed much higher than it was for QE2. First, the perceived cost of QE3 is higher because inflation has accelerated. This reflects the fact that at least some of the weakness in growth this year is due to higher commodity prices, i.e. akin to a supply shock. Second, the perceived benefit from QE3 is lower. Fed officials viewed QE1—defined as the overall balance sheet extension that started in late 2008 and ended in early 2010—as a resounding success, and that was probably one reason why they were fairly quick to climb aboard QE2. But they are much less confident that QE2 made a big difference; while it probably did help financial conditions ease and the economy grow a bit more quickly than it otherwise would have done, it’s hard to argue that the effect was large. That has to color their expectations for what QE3 might deliver. And third, the backlash against QE2 both domestically and abroad was greater than Fed officials had anticipated, and they are not keen to subject themselves to another round of similar criticism.

7. So what is the hurdle for QE3? It probably requires either a meaningful rise in the unemployment rate or flat unemployment coupled with a sharp fall in core inflation and inflation expectations. In contrast, if we just trudge along at a trend or slightly below-trend growth rate and inflation stays near its current pace, neither fiscal nor monetary policy are likely to provide fresh support. Such an outcome might not be so bad from the perspective of the equity market, which already seems to be discounting a fairly weak growth pace. But it would be quite bad for the real economy, not least because it would raise the risk that a significant portion of the increase in unemployment—which still looks cyclical rather than structural at this point—will ultimately become “ingrained” via a loss of skills among the long-term unemployed.”

I think the fiscal side is perfectly accurate. We are a country that has become obsessed and convinced of the idea of our imminent bankruptcy or “Greek moment”. Although that’s monetarily impossible we continue to see our misguided politicians push for fiscal austerity. Of course, in a balance sheet recession fiscal policy is the only thing that can really help offset the negative effects, but our leaders absolutely refuse to try to understand what is going on in the US economy. Therefore, Goldman has it right – fiscal policy is off the table, but only due to sheer ignorance.

What does that mean? It means we’re stuck relying on the Fed and their lack of tools. QE2 has clearly failed at this point, but chatter of QE3 persists. I’ve maintained for over a year now that the Fed was out of bullets. I don’t really think that has changed. Monetary policy is notoriously impotent during a balance sheet recession. One need look no further than Japan for proof of this.

Do they have any options?

The Fed could get creative and actually implement the policy correctly (by setting long rates), but I believe Ben Bernanke is fearful of the market’s response (and rightfully so). QE2 was incorrectly viewed as “money printing” and “debt monetization” so one can only imagine what the media would say if the Fed actually came out and said “the 10 year rate is permanently 3%”. The risk would be a move into commodities that would make the recent surge look like small potatoes. You want to see speculation in asset prices? In other words, QE3 of this sort would likely be even more damaging than QE2 was.

With the balance sheet recession in full effect, it’s useful to continue working from the Japan playbook. Unfortunately, the man running the ship (Ben Bernanke) is using his own inaccurate version of the playbook. In a 2003 speech Dr. Bernanke lectured the Japanese on their possible options. In reading this, you can literally see the steps we’ve followed in recent years. He advocated a muti-faceted approach where monetary and fiscal policy are combined to attack the problem from both ends:

In that spirit, my remarks today will be focused on opportunities for monetary policy innovation in Japan, including specifically the possibility of more-active monetary-fiscal cooperation to end deflation.

…One possible approach to ending deflation in Japan would be greater cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank of Japan should consider increasing still further its purchases of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus.

That sounds pretty familiar doesn’t it? It should because it’s almost exactly what has happened in the last 9 months. Unfortunately, the policy is entirely misguided because the man implementing it doesn’t understand how our monetary system functions (this would sound preposterous if his policies before, during and after the crisis hadn’t failed at every step). He continued his Japan lecture by telling them that they were suffering a disastrous national debt problem and that the only way out was to “finance” tax cuts:

the government’s annual deficit is now about 8 percent of GDP is nevertheless a serious concern….My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt–so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.

All of this is incorrect and proves that Dr. Bernanke does not understand how a fiat currency operates in a nation in which the issuer has monopoly supply in a floating exchange rate system. The problems here are many, but can be summarized in the simple fact that Dr. Bernanke believes the tax cuts need to be “financed”. In other words, QE is necessary to allow the tax cuts to be “paid for”. Of course, a sovereign issuer of currency with monopoly supply of currency in a floating exchange rate system never “finances” its spending. But the good Doctor is working under his entirely defunct gold standard model that no longer applies to the USA. So, aside from the fact that QE was misguided from the beginning, the entire premise from which he is working (that it finances the US government) is completely wrong. It’s no wonder that we took a perfectly good tax cut last year and ruined it by creating a massive gasoline tax in large part thanks to increased commodity speculation.

What’s left to do? How about a fresh start?

I’ve said it for years now – Dr. Bernanke is the wrong man for this job. He lacks an understanding of the US monetary system and the pitiful performance of the US economy speaks for itself. This man did not foresee this crisis, reacted far too slowly when it was a clear danger, responded with the wrong medicine and yet we are still turning to him to solve our problems. Almost 2 years ago I wrote:

To me Bernanke has been like the Fireman who sleeps through the fire alarms, shows up late, sprays gasoline all over the fires making it substantially worse and then claims to have saved the day when he finally puts the fire out after half of your house has already burned down. Or in other words, the Fed Chairman who completely fails to predict the crisis, implements zero risk management tools in advance, nearly drives the economy off the cliff and then takes credit for not destroying the entire economy. Unfortunately for him, his biggest mistakes and “lifesaving” recoveries are likely in the years ahead of him. And unfortunately for the rest of us, we are the ones who are most likely to suffer for his “brilliance” because Lord knows the bankers won’t….

I know the public is demanding too much of him at this juncture and that he lacks the policy tools to fix this crisis, but that’s no excuse for continual policy failures and misinterpretations of our economic plight.

President Obama’s economic team continues to collapse around him. And unfortunately, the two men who played central roles in allowing this crisis to occur remain in the two most influential positions. At this juncture, the very best policy options are for full resignations from Both Dr. Bernanke and Timothy Geithner. They have failed this country and in allowing them to continue down this path President Obama continues to fail us all. Ultimately, the buck stops with the President. His nomination (and reappointment) of both of these men were colossal misjudgments and the economic plight we now face can be directly attributed to them. Their failure is President Obama’s failure.

They say, “if it ain’t broke don’t fix it”. Well, this economy is broken and needs some fixing. The men swinging the tools around trying “experimental policies” aren’t helping. It’s time for real change we can believe in. And that change must start with the two most important positions in economic policy.