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Can the Fed still rejuvenate the economy?

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By Robert J. Samuelson
Monday, October 18, 2010

It is widely, though not universally, assumed that the Federal Reserve will soon move to bolster the economy by trying to nudge down long-term interest rates on Treasury bonds, home mortgages and corporate bonds. Just how much rates would decline and how much production and employment would increase are uncertain. What's clearer is that the move would be something of an act of desperation, reflecting a poverty of good ideas to resuscitate the economy.

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The Fed is suffering an identity crisis. Celebrated under Chairman Alan Greenspan as a guarantor of prosperity, it is now struggling to restore its exalted reputation. In the acute phases of the financial panic, in late 2008 and the first half of 2009, it devised ingenious ways to provide credit to parts of the financial markets (commercial paper, money market funds) that were being abandoned by private lenders. For almost two years, it held its short-term interest rate near zero. All this arguably averted a second Great Depression but obviously did not trigger a vigorous economic recovery.

Chairman Ben Bernanke makes periodic speeches arguing that the Fed still has ample policy tools to revive the economy and reduce the appalling unemployment, despite lowering its short-term interest rate to zero. The reality is otherwise; the Fed's remaining tools are arcane, weak, or both. Says a commentary by Bank of America economists:

"Think of the Fed as a group of soldiers in a foxhole. They have fired their bazooka and their rifle ammunition . . . and they are now using their pistols." What the Fed is expected to authorize, probably in early November, is a large purchase of U.S. Treasury bonds with the intent of driving down their interest rates and rates on other long-term debt securities. It has already done this once. In late 2008, the Fed approved massive bond purchases; these ultimately totaled $1.725 trillion of mortgage-backed securities, U.S. Treasury bonds and Fannie Mae and Freddie Mac bonds. Bernanke has said the program "made an important contribution" to the economic recovery.

But the measurable effects were small. Rates on 10-year government, corporate and mortgage bonds might have dropped by 0.6 percentage points, estimated a Fed study by economists Joseph Gagnon, Matthew Raskin, Julie Remache and Brian Sack. The decline this time might be less, because starting interest rates are already low (about 4.3 percent for a 30-year mortgage) and the purchases might be smaller. Guesses generally range from $500 billion to $1 trillion.

The economists at Bank of America think new purchases would have "only a modest impact on the economy" but are "better than doing nothing." A plausible program might cut the unemployment rate by 0.2 percentage points (say, from 9.6 percent to 9.4 percent), says Moody's Analytics. The stock market would be slightly stronger, leading people to spend more, and a depreciated dollar would aid exports. Indeed, because Bernanke and other Fed officials have signaled a new round of bond buying, financial markets may already reflect some of these effects. This makes it harder for the Fed not to vindicate these widespread expectations.

Still, there are dangers. When the Fed buys Treasury bonds, it pumps dollars into the economy. So far, this hasn't stimulated much borrowing by anxious households and cautious businesses. Outstanding consumer credit has been dropping since the summer of 2008. The Fed might be "pushing on a string," to quote a phrase dating to the 1930s. Banks have excess reserves of roughly $1 trillion. But if all the cheap money spurs much higher economic growth, many of these reserves will turn into loans and raise the specter of higher inflation -- "too much money chasing too few goods." The Fed would then have to withdraw or neutralize the added money through higher interest rates. Adding hundreds of billions more to banks' excess reserves won't make the job easier.

As important, there would be enormous pressure on the Fed not to raise rates while unemployment remains high. Economist Allan Meltzer of Carnegie Mellon University, author of a three-volume history of the Fed, fears that the Fed will -- as in the 1960s and 1970s -- wait too long. "Sooner or later, we'll have a big inflation," he says, "but not right away, because there's no demand now." Economists seem split into two camps. Some, such as Paul Krugman, the New York Times columnist, believe the economy is so weak that the government should do almost anything (bigger deficits, more cheap credit) that might help slightly; and others, such as Meltzer, fear that expedient measures now will lead to bigger problems later. Between them, there's an unstated common presumption that there are no instant cures for the economy's lethargy. The real Fed, it turns out, is much less powerful than the mythologized Fed.


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