Wednesday, August 24, 2011

Dear NYT: The Fed is Impotent, but only by Choice

Catherine Rampell asks "How much more can the Fed help the economy?" and answers that "there are reasons to believe the Fed’s remaining tools may be losing their potency."

However, the evidence she offers is weak. Yes, we're close to the zero lower bound on the Federal Funds rate, but there's really no evidence that all of the other various options the Fed has at its disposal wouldn't work. As written on this blog numerous times, QE announcements and hints have moved markets every time, as did Bernanke's simple statement that he would keep the funds rate low through the middle of 2013 if conditions warrant.

Instead of looking at QE's impact on market prices, Rampell bases her argument around economic performance:
“It’s hard to make the argument that QE2 was a rousing success or we wouldn’t be on the verge of seeing QE3,” the economists at RBC Capital Markets wrote in a client note. “The market may very well get what it seems to desire, but we believe there is no magic bullet here.”
But of course, by this logic, those 7 Federal Funds rate cuts in 2008, when the rate went from 4.25 to 0-0.25 by Q4, 2008, when GDP fell at an 8.9 percent rate, were particularly unhelpful.

Rampell writes that "Twice now the Fed has engaged in large-scale asset purchasing, a process known as quantitative easing." As if two interventions in the past three years is somehow uncharacteristic, especially given that the interventions were split by an increase in the discount rate -- an increase which strengthened the dollar and caused longer-term treasury yields to rise. In normal times, the Fed tinkers with the Federal Funds rate extensively -- in 2008, for example, the Fed cut the Federal Funds rate 7 times, and the discount rate 8 times. In the first 7 months of 2011, by contrast, the Fed made almost no changes to its policy stance whatsoever, despite discovering an economic reality very different from its forecast.

In fact, since 1971, in no three year period has the Fed ever tinkered so little with policy (see here) as it has since the beginning of 2009. This is more than a bit strange given the wide chasm between recent Fed forecasts and economic reality.