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The reluctant Fed

reluctantben.JPG

More from Neil Irwin on why the Fed doesn't want to do more to help the economy:

Fed leadership, however, views the bar as being higher for using such unconventional steps than it is for using the more deeply understood federal funds rate. In other words, it's hard to know exactly how much impact, if any, buying $500 billion of Treasury bonds would have on the economy.

The effect is particularly unclear in an environment where long-term interest rates are already very low; it's not clear that 10-year Treasury bond rates, to which mortgage and other rates tend to be linked, could fall much below their current 2.63 percent level.

The purchases could even be counterproductive, if they lead investors to believe that the Fed will continue printing money indefinitely to fund large U.S. budget deficit, driving up inflation expectations. While some uptick in inflation expectations would be desirable for the economy, the exact influence is unpredictable and expectations could get out of control quickly.

So the Fed won't do more mainly because it's hard to say whether doing more would really help? That seems odd. Maybe the Fed doesn't think it would help but believes that the economy is better off if people think the Fed can still help. It's better for the Fed to be thought reluctant than powerless.

As for the "risk" side of the equation, if inflation starts racing upward, the Fed could simply end the program that's sending inflation soaring. All in all, this reads more like justifying a preference for the Fed's status quo than an explanation of why a thorough review of the options left the Fed convinced that doing more would be worse than doing less.

I'm not a Fed expert. So I try to be deferential on monetary policy: I'm inclined to believe that if the Fed isn't doing something, it has a good reason to not do it. But the more time I spend tracking down the Fed's statements, the more it seems that either the Fed isn't articulating its best arguments or their arguments actually aren't very good.

Photo credit: By Alex Brandon/Associated Press

By Ezra Klein  |  August 17, 2010; 2:20 PM ET
Categories:  Federal Reserve  
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Comments

"The effect is particularly unclear in an environment where long-term interest rates are already very low; it's not clear that 10-year Treasury bond rates, to which mortgage and other rates tend to be linked, could fall much below their current 2.63 percent level."

In Japan, the 10 year is sitting at 0.95%. So rates could fall much below that level.

"The purchases could even be counterproductive, if they lead investors to believe that the Fed will continue printing money indefinitely to fund large U.S. budget deficit, driving up inflation expectations. While some uptick in inflation expectations would be desirable for the economy, the exact influence is unpredictable and expectations could get out of control quickly."

I don't think this is much of a risk. It would be hard for the Fed to generate out of control inflation expectations on buying hundreds of billions of Treasuries when a credit bubble measured in the tens of trillions is deflating.

The biggest risk is that the Fed blows another bubble. More likely the Fed is ineffective, becaue there are no bubbles to be blown. It is also possible that we see a sudden surge in economic activity similar to the U.S. going off gold in early 1933.

The Fed should adopt Scott Sumner's proposal of targeting NGDP expectations, level targeting imply 5% growth/yr with 2007 as the base year. It's hard for the Fed to let expectations get off track if it is targeting an explicit time path for NGDP. If NGDP targeting works, the Fed should keep level targeting and over the next 5-10 years reduce the target so that there is no inflation, and if it fails we should acknowledge the Fed is ineffective when we need it and get rid of it altogether.

Posted by: justin84 | August 17, 2010 2:51 PM | Report abuse

"The purchases could even be counterproductive, if they lead investors to believe that the Fed will continue printing money indefinitely to fund large U.S. budget deficit, driving up inflation expectations."

Expectations for future inflation are exactly what we need to drive spending and hiring and end the current slump. "The danger of a deliberately inflationary program is that it might drive inflation!" :facepalm:

Posted by: guided | August 17, 2010 3:07 PM | Report abuse

You certainly aren't a Fed expert Ezra.

You really aren't an expert in anything. You basically just take every situation, assume that something MUST be done, and then you figure out what the most compassionate (read liberal) possible something would be.

Once you've managed to get this far, you take your basic - I read a Wikipedia article on it - understanding, and you try to come up with an analogy that some simpleton who pays no taxes would understand.

Finally, you declare the situations are exactly the same and that its obvious what should be done!

Such a hack

Posted by: donopj2 | August 17, 2010 3:07 PM | Report abuse

"In Japan, the 10 year is sitting at 0.95%. So rates could fall much below that level."

It's called pushing on a string.

Posted by: tuber | August 17, 2010 3:44 PM | Report abuse

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