Joe Gagnon on the Peculiar Case of the Fed in the Nighttime
Joe Gagnon:
RealTime Economic Issues Watch | The Fed Shirks Its Duty: On June 20, 2012, the Federal Reserve… extinguished the last shred of doubt as to whether it intends to achieve its mandated objectives. Despite a substantial markdown of an already inadequate forecast, the Fed did not take any actions that would make it possible to achieve either of its objectives over the foreseeable future…. For more than two years, the Fed has dragged its feet and resisted the obvious need for more aggressive action. At this point it is not clear that the Fed has the tools it needs to get the best possible outcome without help from fiscal policy. Nevertheless, the Fed has considerable firepower remaining. It should aggressively push down mortgage interest rates and state clearly that it would welcome an inflation rate temporarily above its 2 percent target in order to make faster progress on its employment objective. These measures, discussed below, would substantially improve the economic outlook, even if there is disagreement about whether they are sufficient by themselves.
A number of well-known Fed watchers have wrung their hands in despair at this policy paralysis. What lies behind the Fed's inaction?…. Harvard professor Martin Feldstein… argues that the sluggish recovery proves that monetary policy has lost its potency. He has succumbed to the fallacy of the driver who wonders why pressing on the accelerator does not cause the car to speed up as it starts to climb a hill…. Tim Duy… wonders if the uncertainty over the effect of unconventional monetary actions has caused the Fed to be so timid. One thing is certain: Unconventional actions taken to date have not been sufficient…. Surely the lesson must be to take larger steps, not smaller ones. Ryan Avent… suggests that concern about unspecified "costs and risks" is the most likely reason the Fed is not taking more aggressive actions…. Paul Krugman guesses that the Fed is intimidated by Congressional Republicans….
After his dissenting vote last week, the president of the Federal Reserve Bank of Richmond, Jeffrey Lacker, stated: "I do not believe that further monetary stimulus would make a substantial difference for economic growth and employment without increasing inflation by more than would be desirable." The view that unconventional monetary policy will lead to inflation is commonly held on Wall Street. Yet, more than three years after the launch of such policies, inflation remains at or below the Fed's target…. A large majority of the committee projects that inflation will be below target over the next two and a half years. If they assign any weight to their employment objective, they should be willing to accept inflation at least modestly above target in order to get a better outcome on employment….
The best option within the Fed's legal authority is to announce a target range for the 30-year mortgage rate of 2.5 to 3 percent to be maintained for the next 12 months. This target would be enforced through unlimited purchases of MBS guaranteed by the federal housing agencies…. The Administration could help by forcing the housing agencies to stop dragging their feet on refinancing and loan modifications…. Although not a panacea, the above measures are substantial and would be viewed as such by market participants…. Raising expectations of future inflation moderately--in conjunction with a continued commitment to a near-zero policy rate--would lower the real interest rate, providing additional impetus to economic activity….
The main alternative instrument in the Fed's toolkit is foreign exchange….
The best alternative would be to purchase exchange-traded funds of the total US stock market. That would have broad-based benefits, repairing household balance sheets and unlocking consumption and investment. Unfortunately, the Fed is not authorized to buy equities and Congress is not likely to grant it that power anytime soon.
