Why is the Fed afraid of succeeding?
After three consecutive months of strong job growth, officials at the Federal Reserve are feeling less pressure to act aggressively to support the recovery. Instead of beginning another round of large-scale asset purchases, or quantitative easing, the Fed now seems posed to adopt a more modest measure that is being dubbed “sterilized” QE.
The Marriner S. Eccles Federal Reserve Board Building, the location of the main offices of the Federal Reserve Board of Governors.
This would mark the latest in a long line of frustrating and perplexing mistakes by the central bank. Although job growth has been robust for several months, the numbers, which range from 227,000 in February to 284,000 in January, are simply not good enough given the scale of the economic devastation wrought by the Great Recession. And they pale in comparison to job growth following previous recessions of comparable depth and duration.
Except for May 2010, when temporary census-related hiring was at its peak, job growth has failed to top 300,000 in the 32 months since the recession officially ended. By comparison, job growth exceeded this figure 12 times in the 24 months that followed the end of the 1981-82 recession. During the Clinton years, a 300,000-plus jobs report was common, even though the economy was much closer to full employment than it is now. And the six years between the 2001 recession and the Great Recession, a time of so-so economic growth, saw seven months with greater than 300,000 jobs created.
Recent job growth might reasonably be considered robust if the economy were anywhere close to normal, but with the unemployment rate still above 8 percent and the economy 5 million jobs short of the pre-recession peak, suggestions that the current pace of recovery is “good enough” are downright absurd. So what explains the Fed’s sudden complacency?
The answer: an irrational and unfounded fear of inflation. Although inflation has run below target for much of the last four years, and inflation expectations remain slightly below target over both the short and medium term, the Fed continues to cite concerns about inflation in its argument for limited action. The Fed’s new sterilized bond-buying program was, according to The Wall Street Journal, designed “to relieve anxieties that money printing could fuel inflation later.”
Those anxious about the inflationary impact of Fed policy fall into two distinct camps, both of which are wrong in their own ways.
The first camp fears that the massive expansion of the Fed’s balance sheet since late 2008 represents an inflationary time bomb that could explode at any moment. Although this might seem like a legitimate concern, the experience of Japan should put it to rest: Despite conducting several large quantitative easing programs, the Bank of Japan has presided over two decades of deflation. If QE is inflationary, the Japanese never got the memo.
The reason for this is simple: Only permanent increases in the monetary base are expansionary. Since the Bank of Japan has a reputation for reversing its actions once deflation subsides, QE is accompanied with the expectation that it will later be reversed.
Indeed, in making the case for fiscal stimulus, economist and New York Times columnist Paul Krugman has argued that quantitative easing is ineffective precisely because central banks have difficulty convincing the public that their large-scale asset purchases represent permanent increases in the monetary base. For quantitative easing to be stimulative, he argues, the Fed would have to be “credibly promise to be irresponsible.” That is, it would have to convince the public that, unlike the Bank of Japan, it would not reverse course as soon as inflation begins to rise modestly.
This explains why the huge expansion of the monetary base since late 2008 has coincided with a four-year period of low inflation: The Fed has made it clear that its current policies are merely temporary and will be unwound once the economy recovers. It has also suggested that even a modest rise of inflation above its long-run target of 2 percent would be undesirable. Under these circumstances, it is no surprise that the predicted inflationary time bomb has never gone off: The Fed has committed itself, in no uncertain terms, to reversing course as needed to prevent this scenario from unfolding.
The second camp of inflation hawks, unfortunately, lacks even the logical coherence of the first. Seeing 8-plus percent unemployment and an unacceptably slow pace of recovery, the second camp wishes to God that the Fed could do more, but then expresses its grave concern that further action will cause inflation to rise. To the second camp, sterilized QE is the ideal policy because it allows the Fed to act to support the economy while avoiding a concomitant rise in inflation. But any action, whether monetary or fiscal, that successfully stimulates the economy by boosting demand will necessarily lead to higher inflation. The second camp wants to have its cake and eat it, too.
As it turns out, the hard-money advocates are right: Fears of inflation are holding back recovery. But the problem is not that the private sector, spooked by the specter of imminent hyperinflation, is being stymied. Rather, the problem is that the Federal Reserve, in its nearly single-minded obsession with a non-existent problem, has stopped short of deploying the considerable array of tools at its disposal to full effect.
The Fed is like a man who wants to warm his house in the dead cold of winter, but is afraid to turn on the heat lest it lead to a rise in the temperature. The Fed, that is, seems horrified at the thought that its policies, if pursued with the appropriate vigor, will actually lead to success. It’s a shame we all don’t face such difficult choices.
Alex Hudson is co-founder and Senior Editor at Partisans. He was previously a Fulbright Scholar to the United Kingdom, based at the University of Oxford. He is a PhD candidate in Chemistry at the University of California at Berkeley.