Remember the glory days from the mid-1990s to the 2008 financial crisis when the Federal Reserve appeared infallible? Fed Chairman Alan Greenspan was the “maestro.” The Fed could, it seemed, prolong economic expansions and shorten slumps. From 1982 to 2007, there were only two mild recessions. Financial crises were defused. Recall how the collapse of the “tech bubble” in 2000 was contained.
Those days are gone. Despite the Fed’s dramatic interest-rate cuts and massive purchases of Treasury securities, the recovery lags even after Friday’s jobs report (payroll jobs: up 200,000; unemployment: down 0.2 percentage points to 8.5 percent). A desperate Fed is grasping at almost anything to stir the economy from its lethargy.
Evidence of the frustration surfaced in two actions this past week. On Tuesday, the Fed revealed that members of the Federal Open Market Committee (FOMC), its main decision-making body, would begin providing detailed forecasts of future interest rates. The next day, the Fed sent a 26-page report to Congress with suggestions on how to revive the ailing housing sector.
Neither move will boost the economy much. Both reflect the Fed’s impatience and desire not to be seen as passive.
Start with the housing report. It brims with grim reminders of the problem. Since their peak in 2006, home prices have dropped about a third, representing $7 trillion of lost value. The ratio of home equity to disposable income is 55 percent, the lowest since 1950, when these calculations began. Only a few years ago, the ratio peaked at about 140 percent. Some 12 million homeowners are “underwater”: Their homes are worth less than their mortgages. Declines in home equity for middle-income families (2007 household incomes of $40,000 to $65,000) averaged 66 percent, almost twice the 36 percent drop for high-income households (2007 incomes exceeding $150,000).
One Fed idea is that foreclosed homes owned by Fannie Mae, Freddie Mac and the Federal Housing Administration — about half of all homes owned by financial institutions — should be sold more quickly. But the Fed can’t compel that. The power resides with the housing agencies and their federal regulators: the Federal Housing Finance Agency, the Treasury and the Department of Housing and Urban Development. The Fed report seems mainly an attempt to prod others to do more.
By contrast, the decision to have the FOMC forecast interest rates represents a big shift in Fed procedures. Each individual member of the FOMC would predict changes in the federal funds rate: the rate on overnight loans between banks. Changing the Fed funds rate is the main instrument by which the Federal Reserve influences the economy and broader interest rates. Since late 2008, the Fed funds rate has been near zero, and the FOMC has already said it expects to keep it there through at least mid-2013. If FOMC members project low rates beyond mid-2013, this might — the reasoning goes — nudge rates on long-term bonds and mortgages even lower. These lower rates would then aid the recovery by promoting borrowing and boosting the stock market.
But even this effect may be modest, because long-term interest rates are already so low. In December, rates on top-rated corporate bonds and conventional mortgages were slightly below 4 percent. On 10-year Treasury bonds, they were about 2 percent.
As a permanent change in Fed policymaking, the impact of interest-rate forecasts is unclear. The general idea is that the Fed should become more “transparent.” The more outside investors know about its views — the theory goes — the more likely they are to conform their actions to the Fed’s intentions. There will be fewer surprises, and the Fed will have an easier time achieving its goals. That’s the theory.
In practice, it may not work, because the economy changes too often to make interest-rate predictions reliable. Many studies have confirmed that forecasts, including those of the Fed, regularly miss main outcomes (economic growth, inflation and unemployment). If the economy can’t be forecast, then interest-rate predictions based on faulty forecasts may create false confidence. They may provide a poor guide to future policy.
Time will tell. Meanwhile, the Fed is striving to debunk the notion that it can’t do much more to promote recovery. But how much of this is policy and how much is public relations?