The minutes to The Federal Reserve meeting on November 3rd were released today and showed an unusual amount of disagreement about the state of the economy and what the Fed should do about it. Below are the key sections of the minutes. In between, I insert my commentary/translation.
“Participants generally agreed that the most likely economic outcome would be a gradual pickup in growth with slow progress toward maximum employment. They also generally expected that inflation would remain, for some time, below levels the Committee considers most consistent, over the longer run, with maximum employment and price stability.”
The Fed, by law, is supposed to both maintain price stability and foster full employment. It looks like things are coming in too weak on both counts. To my mind, this calls for the Fed to have an easy monetary policy. Since the Fed Funds rate — the normal tool that the Fed uses to influence monetary policy — is already effectively at zero, it means they have to use unconventional tools.
“However, participants held a range of views about the risks to that outlook. Most saw the risks to growth as broadly balanced, but many saw the risks as tilted to the downside. Similarly, a majority saw the risks to inflation as balanced; some, however, saw downside risks predominating while a couple saw inflation risks as tilted to the upside.”
With fiscal policy on the verge of being tightened, and the stimulus from the ARRA wearing off, count me as one of those who sees the risks to growth tilted to the downside. With unemployment at 9.6% and capacity utilization far below the long-term average, in the absence of further monetary easing, I also see the inflation risks as tilted to the downside.
With core inflation at a record low level (year over year just 0.6%, and 0.0% over the last three months), any further decline will push us over the edge towards actual deflation. We do NOT want to go there.
“Participants also differed in their assessments of the likely benefits and costs associated with a program of purchasing additional longer-term securities in an effort to provide additional monetary stimulus, though most saw the benefits as exceeding the costs in current circumstances.
“Most participants judged that a program of purchasing additional longer-term securities would put downward pressure on longer-term interest rates and boost asset prices; some observed that it could also lead to a reduction in the foreign exchange value of the dollar.”
Some commentators — and certainly the Germans and the Chinese — see the reduction in the value of the dollar as a bug. I see it as a feature, and one of the most important ways that easier monetary policy will stimulate the economy. The trade deficit is a huge drag on economic growth, and a weaker dollar will make our exports more competitive and imports more expensive. If imports are more expensive, some of that demand will be filled by domestic production.
To the extent that QE raises inflation expectations/diminishes the expectations that we will fall into deflation, the effect of the Fed’s buying of longer term T-notes could be ambiguous. The extra buying pressure acts to force down nominal rates, but that is offset by higher inflation expectations. In any case, though, the program will lower real long-term rates.
“Most expected these changes in financial conditions to help promote a somewhat stronger recovery in output and employment while also helping return inflation, over time, to levels consistent with the Committee’s mandate.”
The key words here are “over time.” As Lord Keynes famously observed, “In the long run, we are all dead.”
“In addition, several participants argued that the stimulus provided by additional securities purchases would help protect against further disinflation and the small probability that the U.S. economy could fall into persistent deflation—an outcome that they thought would be very costly.”
The threat of deflation is not all that small. While the probability may well be below 50%, it is not trivial either, particularly if QE2 were not undertaken.
“Some participants, however, anticipated that additional purchases of longer-term securities would have only a limited effect on the pace of the recovery; they judged that the economy’s slow growth largely reflected the effects of factors that were not likely to respond to additional monetary policy stimulus and thought that additional action would be warranted only if the outlook worsened and the odds of deflation increased materially.”
Additional monetary stimulus is a poor substitute for what the economy really needs, more fiscal stimulus. With the banks already sitting on a huge pile of excess reserves, it very well could be that the Fed is pushing on a string. Fiscal stimulus would be much more effective.
Unfortunately, with the new Congress, the existing fiscal stimulus is going to be cut off, and certainly not renewed. The patient needs amphetamines, the Fed is giving it a cup of coffee. The new Congress wants to prescribe barbiturates.
“Some participants noted concerns that additional expansion of the Federal Reserve’s balance sheet could put unwanted downward pressure on the dollar’s value in foreign exchange markets.”
Who said it is unwanted? The Chinese? The Germans? The Japanese? Certainly not the millions of unemployed who would go back to work if the trade deficit was not a consistent drag on the economy. Just how far into debt to the rest of the world do these clowns really want the U.S. to get?
“Several participants saw a risk that a further increase in the size of the Federal Reserve’s asset portfolio, with an accompanying increase in the supply of excess reserves and in the monetary base, could cause an undesirably large increase in inflation. However, it was noted that the Committee had in place tools that would enable it to remove policy accommodation quickly if necessary to avoid an undesirable increase in inflation.”
With this much slack in the economy the risk of runaway inflation is extremely low — far lower than the probability of deflation. And yes, the tools are there to contain inflation in the very unlikely case that it starts to overheat.
With the yield on the 10-year T-note at 2.8%, it is extremely clear that the bond market does not fear runaway inflation at all. The only scenario under which a rational person would lock up their capital for ten years is one in which inflation stays very low, close to zero, or actually negative.
The Fed did the right thing in launching the QE2, and the critics are totally off-base. I suspect that many of them want the economy to stay as soft as possible for political reasons. This politization of the Central Bank, and the potential loss of Fed independence, is dangerous.
Zacks Investment Research
