The uncharted waters into which the Federal Reserve sailed in 2008 could become even more treacherous in the year ahead.
Will the unprecedented measures that the Fed, the Treasury, the Federal Deposit Insurance Corporation and other authorities took last year succeed in at last stabilizing the financial system and reviving a torpid economy? Or will the housing mess cause the economic/financial crisis to drag on?
With the answers to those questions unknown, the forward-looking Fed must try to navigate between the Scylla of potential accelerating inflation and the Charybdis of possible deflation.
The downwardly revised quarterly forecast compiled by the Fed’s policymaking Federal Open Market Committee last fall projects real GDP growth of between -0.2% and 1.1% in 2009, before rising to 2.3% to 3.2% in 2010 and 2.8% to 3.6% in 2011.
But the FOMC “view(ed) uncertainty about the outlook for economic activity as higher than normal.” Recession, falling oil prices and dollar appreciation led FOMC members to forecast a deceleration in core inflation from 2.8% to 3.1% in 2008 to 1.3% to 2.0% in 2009. But there’s nothing certain about that either.
As always, the FOMC forecast is based on an “assessment of appropriate monetary policy” over the forecast period. But that’s hard to quantify. Some fear accelerating inflation. Others talk of deflation. The Fed goes into 2009 with a depleted, though not exhausted, monetary toolkit after a year of extraordinary policy exertion. Beyond what Chairman Ben Bernanke calls its “exceptionally rapid and proactive” interest rate cuts, the Fed liberalized discount window lending, augmented it with the Term Auction Facility (TAF) and gave non-bank financial firms access to Fed credit.
When the crisis intensified in September, the Fed created more new facilities to rescue commercial paper and money market funds.
And, of course, it came to the aid of AIG and Citigroup. Meanwhile, the Treasury was injecting capital into banks and the FDIC was expanding deposit insurance and guaranteeing interbank loans.
The Fed’s aggressive liquidity provisions more than doubled the Fed’s balance sheet, leading to explosive expansion of bank reserves and the monetary base. Despite the Fed’s best efforts to set a floor under the Federal funds rate through paying interest on reserves, the funds rate has consistently undershot the FOMC’s target.
Fed Vice Chairman Donald Kohn and other officials have admitted the Fed is engaging in “quantitative easing.” Starting in October, it stopped sterilizing all of its open market operations.
In late November the Fed said it would buy $100 billion of debt issued by Fannie Mae, Freddie Mac and Federal Home Loan Bank securities and $500 billion in mortgage-backed securities guaranteed by the government sponsored enterprises. Bernanke mused about buying “substantial” further amounts of GSE and long-term Treasury bonds to lower long-term interest rates and boost the economy. And there are other things it could do, such as buying foreign sovereign debt.
Unsterilized, or outright purchases of government securities, amount to monetization of government debt — something usually associated with Latin American central banks or, in recent years, the Bank of Japan.
So far the Fed’s measures have not caused accelerating inflation. In fact, it’s moderated. Financial markets are not functioning normally. Banks are building up excess reserves and curbing lending. With GDP contracting and consumers retrenching, the multiplier effect of all that “high powered money” is minimal.
But if hopes for a second half rebound and a 2010 return to trend growth prove true, all that quantitative easing and debt monetization could become very inflationary indeed. Bernanke acknowledged as much. “To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed’s balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way,” he said.
“However, that is an issue for the future,” he said. “For now, the goal of policy must be to support financial markets and the economy.”
Richmond Federal Reserve Bank President Jeffrey Lacker, one of this year’s FOMC voters, said “monetizing the debt” is sometimes “necessary to prevent deflation... You also do it to stimulate the economy when further reductions in interest rates are infeasible.”
But he warned, “We have to be careful about withdrawing it before it sparks a run-up in inflation.” Withdrawing monetary stimulus “in a timely way” may prove problematical given the uncertain outlook and the lags with which policy works. As long as the Fed remains concerned about the “adverse feedback loop” between the financial crisis and recession and so long as there is even a small risk of deflation, the Fed will be inclined to maintain its super-accommodative stance.
But the resilient U.S. economy could rebound more quickly than expected once housing and financial markets finally stabilize. Waiting until recovery is at hand to normalize policy runs the risk of leaving rates too low, too long, which is part of the reason we got into this mess in the first place.
Steve Beckner is senior correspondent for Market News International and is regularly heard on NPR. He is the author of “Back from the Brink: The Greenspan Years” (Wiley).