Fed policy clash may undermine recovery efforts

As the Federal Reserve prepares to take what is expected to be new action to stimulate the economy this week, divisions at the central bank may be undermining its efforts to speed up economic growth and lower unemployment.

After the Fed concludes its policymaking meeting Thursday, the central bank is all but certain to extend its plan to keep interest rates low, moving the possible cutoff to 2015 from 2014. Many economists also expect the Fed to launch a bond-buying program targeting the mortgage market.

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The guidance on interest rates is supposed to encourage businesses and consumers to invest and spend, stimulating the economy, while the bond purchases are designed to further lower interest rates.

But disagreements within the Fed risk muddying the central bank’s message, a problem that many economists say could make its efforts ineffectual and possibly counterproductive.

The economists note that the Fed plans to keep interest rates low for an extended period only because it believes the economy will be weak until then. This approach not only may make consumers and businesses fear a long period of economic malaise, but also suggests that the Fed will start to raise rates if the economy shows signs of recovery.

“You are changing expectations in a way that makes people even more reluctant about how they’re going to spend,” said Michael Woodford of Columbia University, who recently wrote a major paper on the subject. “That’s a large part of the problem with the economy — a lot of people are saying, ‘We should wait and see.’ ”

The Fed is led by Chairman Ben S. Bernanke and six governors, based in Washington, and the 12 presidents of regional Federal Reserve banks across the country. The members have openly clashed over whether the weak economy needs significantly more stimulus, or whether additional actions by the Fed could set off a difficult-to-control bout of inflation.

Bernanke has nudged the central bank in the direction of more action, relying in part on a strategy of communicating to the public the Fed’s plans to keep rates low even if the economy begins to recover. But the Fed’s policy statements haven’t been so explicit, reflecting the differences among senior officials.

“Their biggest communication problem is they can’t come to terms with individually what they think is best. Because they don’t agree what is best,” said Vincent Reinhart, chief U.S. economist for Morgan Stanley and a former senior Fed economist.

What Woodford and many other economists, such as Princeton’s Paul Krugman and former Council of Economic Advisers chairman Christina Romer, would like is for the Fed to make a firm commitment to holding interest rates low until the economy is fully healed — or, in other words, economic growth catches up to what it would have been if not for the 2008 financial crisis and Great Recession.

Fed officials are cognizant that their policies may not have sent as clear a signal as they hoped. They have been searching for additional steps they could take to assure the public that they do intend to hold interest rates low even as the economy gains momentum. Among the options under consideration is simply including such a promise in an upcoming policy statement.

But the Fed has resisted more dramatic actions such as those advocated by Woodford, or a less aggressive idea popularized by Charles Evans, the president of the Federal Reserve Bank of Chicago. Evans has called for the Fed to agree to hold interest rates low until unemployment, now at 8.1 percent, declines to 7 percent, or inflation rises above 3 percent.

Others on the Fed board don’t agree, though, because they are worried that allowing inflation to rise beyond the target of 2 percent would make it difficult to contain.

Economists say that on Thursday there’s a high probability the Fed also will launch a new round of bond purchases targeting the mortgage market. These purchases are designed to bring down interest rates. In the past, the Fed has agreed to purchase only a fixed amount of securities, suggesting to the public that the central bank’s support for the economy would end at a fixed date.

One option going forward would be to make bond purchases open-ended, only concluding when the economy recovers.

In any event, with interest rates already low and the stock market booming, many economists don’t expect new asset purchases to have much of an effect. “We’re talking about tenths of a percentage point on unemployment and GDP growth. We’re not talking about a major mover, but every little bit helps,” said Peter Hooper, chief economist at Deutsche Bank Securities.

In January, the Fed extended its interest rate guidance from 2013 to 2014, and announced a bond-buying plan in June.

And though interest rates have fallen since then, the ultimate impact on the economy has been modest at best. Most strikingly, there has been virtually no improvement in the labor market this year. The percentage of the population that has a job was lower in August than at any point this year — resting at a nearly three-decade low.

 
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