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The Fed's Wait and See Policy is a Mistake

Last Updated Aug 27, 2010 10:24 PM EDT

Federal Reserve Chair Ben Bernanke said the things he was expected to say in his speech today: The Fed's actions to date helped to avoid an even worse crash of financial markets and the broader economy, the economy is recovering, but much more slowly than the Fed anticipated, and the Fed has additional steps it could take to combat the weakness in the economy.

So why not take them? According to Bernanke:
The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.
Based upon its forecasts and, assessment of conditions, thee Fed does not believe the benefits outweigh the costs. When might the Fed do more?:
Each of the tools that the FOMC has available to provide further policy accommodation--including longer-term securities asset purchases, changes in communication, and reducing the IOER rate--has benefits and drawbacks, which must be appropriately balanced. Under what conditions would the FOMC make further use of these or related policy tools? At this juncture, the Committee has not agreed on specific criteria or triggers for further action, but I can make two general observations.
First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.
Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.
There are steps the Fed can take, Bernanke outlines four, quantitative easing, a change in communication about the Fed's intent regarding keeping interest rates low, a change in the rate paid on bank reserves, and a change in the inflation target, though he says only the first three are viable options. However, presently the Fed does not feel the benefits outweigh the costs, and it remains in "wait and see" mode.

My first question for the Fed would be this. To date, you have underestimated overestimated the strength of the recovery at every step. Presently, you believe that the economy is still recovering, albeit slowly, but do you see the risks around that forecast as symmetric? Given the forecasts to this point, all of which have been too rosy, I would place more weight on the downside, quite a bit more, but it's not clear the Fed is doing this.

The Fed apparently does not weight the downside risk as highly as I do (which includes extended stagnation), and they have different weights than I do on the benefit of reducing unemployment versus the potential costs of more action such as inflation and market collapse. So the Fed sees no need to act now.

I don't think the inflation fear is very large, and the Fed has new tools to battle it in any case. In fact, the inflation risk is just the opposite of what the Fed is telling us. Bernanke says that inflation expectations are well-anchored, but a look at the data we have shows that expectations are falling along with actual inflation. Disinflation/deflation is the risk right now, and it's larger than the Fed is acknowledging.

I also view the unemployment risk, risks such as long-term unemployment turning into a permanent structural problem, as being much higher that the Fed seems to. The benefits of reducing unemployment are larger than the Fed apparently realizes.

So, in my view, the Fed should drop its relatively rosy forecast for the recovery and take more account of the downside risks, the Fed should place more weight on the unemployment problem, and have less fear of inflation -- the risk right now is in the other direction. Making these adjustments that would compel the Fed to action instead of "waiting and seeing," a policy that, to date, has kept the Fed from getting out in front of the economy's problem.

It's time for the Fed to stop playing catch-up as it waits and sees that its forecasts were wrong, and and take the steps needed to boost the economy.