Friday, October 15, 2010

To Ease or Not To Ease

I have now been grappling with the issue of federal reserve action and credibility for some time. Tyler Cowen's piece in the NYT sums up the sort of cost-benefit thinking I've been going through in relation to the Fed's non actions to stimulate the economy:

"Sadly, although Mr. Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction. This is understandable, because if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. All of a sudden, the Fed would end up “owning” the recession...In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?"

The benefits of a new rounds of quantitative easing seem very uncertain, at best. The threat to the fed's credibility as an effective stabilizer of the economy if QE fails may in fact be true, such as occurred to the Bank of Japan during its long slog. A note to be made to this is the reason the BOJ looks so impotent now may stem from the inability to get their act together and really prime the economy, but that's a completely debatable issue.

The one thing that does seem clear to me, though, is if Chairman Bernanke decides to take the QE approach, it should be an all-or-none, guns-blazing, helicopter bill dropping economy priming fest. If the Fed makes the bold promise that they will step in to correct a downward spiraling economy, as they have, and fail to deliver the job, then their credibility will take a hit. I think the best example of this is in the recent anti-stimulus furor. The Obama administration passed a stimulus that was too small, and primarily focused on tax cuts, yet they sold it as a Keynesian cure-all. When things did not turn out as well as they had hoped, not only had the administration been discredited but the act of stimulating the economy vis-a-vis fiscal policy seemed to go down with them. This is why a QE approach that is lackluster is worse than no QE at all. Unfortunately, according to Tim Day, the approach the Fed is taking will not be close to enough:

"Bottom Line: Right now, I have more questions than answers. The US economy is operating below potential to the tune of about a trillion dollars give or take...For better or worse, that leaves monetary policy to bear the burden. But the Federal Reserve is signaling they are poised to deliver far less than necessary to meet expectations, expectations that already were likely overly optimistic. Truly, it boggles the mind, and suggests that Bernanke is far more worried about the specter of inflation than the real pain of unemployment."

This is a sad state of affairs. If Bernanke really places Fed credibility above everything else, he should stay out and leave the table all-together. If, however, he believes credibility rests in jump-starting the economy, he should push all his chips in now. Over time no matter how hard he tries just placing small bets, he will inevitably be pulled into the fray when the economy does not grow fast enough. Muddling through helps no one.