Reckless Fed

10 Aug 2011 by Jim Fickett.

The Fed has promised to keep rates at zero for two years. No one, especially not someone who relies on Dynamic Stochastic Generalized Equilibrium models, can predict economic conditions even a few months in advance, much less two years. The likelihood of either a new debt bubble leading to a financial crisis, or serious inflation, just went up substantially.

Today the Financial Times gave a nice explanation of current Fed policy:

If he could speak in plain English, maybe Ben Bernanke would have expressed himself thus: “We have to do something to turn markets round and to put the S&P sovereign downgrade behind us. We do not have time to thrash out a new round of quantitative easing through bond purchases and, with inflation expectations still higher than they were when QE2 started, that would be hard to justify.

“But a promise to leave rates where they are now (virtually zero) for two more years is a big deal. First, we are tying our hands, since central banks are nothing without their credibility. Second, since target rates will stay low for two full years, it is safe to push the yield on two-year Treasuries down to almost nothing. That has the same effect as QE. The Fed can also do some quasi-QE by selling bonds on its balance sheet and using the proceeds to buy longer-dated paper on the market.

“Of course, this means letting the dollar tank. Other countries will hate us. So be it. And, obviously, low rates could stimulate inflation. But, frankly, we would be only too happy for inflation to rise a bit. The key to getting through this rough spot is that everyone calms down and sees that they have no choice but to buy risky assets.”

The actual statement on the overnight rate is a little less definite than generally reported,

The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Nevertheless, markets are indeed counting that as a promise to keep rates at zero for two years – an extremely reckless promise. As David Merkel rhetorically asks Bernanke,

  • Isn’t stagflation a possibility here? I mean, no one expected it in the ‘70s either.
  • Could we end up with another debt bubble from keeping short rates so low? …
  • Is it possible that you don’t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?

The Fed is not only in totally uncharted waters, but is promising not to react to reality for two years. That is nothing short of terrifying.