Pressure Mounts on Fed to Save Recovery

By John W. Schoen
|  Tuesday, Aug 10, 2010  |  Updated 5:00 PM EDT
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Pressure Mounts on Fed to Save Recovery

AP

With the economy sputtering and Congress all but shut down until after the November election, the Federal Reserve is now the last best hope of restoring growth and getting Americans back to work.

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It’s all come down to the Fed.

With the economy sputtering and Congress all but shut down until after the November election, the Federal Reserve is now the last best hope of restoring growth and getting Americans back to work.

But after exhausting its conventional policy arsenal, the central bank is now considering measures of last resort never tried in its nearly 100-year history. No one knows whether they will work. But some Fed watchers argue that the central bank can no longer afford to wait for clearer signs the Great Recession is over.

“The data is weakening, the recovery is losing momentum,” said Mohamed El-Erian, co-chief investment officer at Pimco. “If we don't do something about it now, it’s going to be much harder to do something about it later on.”

At its latest rate setting meeting Tuesday the Fed’s Open Market Committee acknowledged the slowing economic data that has been flashing yellow since it last met six weeks ago.

"The pace of recovery in output and employment has slowed in recent months," the central bankers said in their offocial statment Tuesday. "The pace of economic recovery is likely to be more modest in the near term than had been anticipated."

But the panel stopped short of announcing its next move — largely because the path ahead is anything but clear-cut.

With the impact of massive government stimulus spending fading, the economy is slowing down again, leaving nearly 15 million American stranded without a job. Those lost paychecks, in turn, are holding back growth.

The latest data from the Commerce Department show that Gross Domestic Product slowed to 2.4 percent in the second quarter compared to 3.7 percent in the first three on the of the year. Economists have been paring their growth estimates for the rest of the year; Goldman Sachs recently cut its forecast to just 1.5 percent GDP growth through the middle of next year.

More government stimulus spending might help give growth another lift, but with Congress about to face voters angry about runaway budget deficits, that isn’t likely. A recent vote to continue unemployment insurance for long-term jobless workers prompted a protracted debate before a scaled-down measure was approved.

The White House Tuesday hailed passage of a $26 billion package of state aid designed to head off massive layoffs of government workers. But the measure likely won’t stop the bleeding; state budgets are expected to come up short by more than $100 billion — in the current fiscal year alone.

With the Bush administration’s tax cuts set to expire next year, taxes will automatically rise unless Congress acts, creating a further drag on the economy. But while tax policy is being hotly debated on the campaign trail, odds are waning that lawmakers will address the matter until the eleventh hour. That uncertainty has already prompted some companies to postpone expansion plans.

All of which leaves the Federal Reserve as the last best hope for restoring growth. But despite massive infusions of cash, credit is still tight.

Consumers have pared back debt. Consumer credit fell by $1.3 billion in June, the fifth consecutive drop, bringing total contraction for 2010 to $34 billion.

Companies — especially small businesses — are having a hard time getting a loan. Despite healthy profits and record low cost of funds, the money supply continues to shrink as bankers stash more of their cash in the vault. So it’s not clear that the usual Fed policy pumping more cash in the system to boost the economy would have much impact.

"The Fed is saying to the banks, 'Look, there’s much more liquidity here if you want to lend more,' " said Nigel Gault, chief U.S. economist at IHS Global Insight. "And the banks are saying, ‘No thanks. At the moment, we don’t want to lend more because we don’t want to take the risk.' "

Current policy is tilted slightly toward encouraging that cash hoarding; the Fed pays banks a quarter-percent interest on money they keep in the central bank’s vault. One option to spur lending is to cut that payment, but Fed watchers say such a move would have little impact on lending.

Deflation threat
To get more money in the hands of consumers and businesses, the Fed has already slashed short-term interest rates close to zero; on Tuesday, the FOMC affirmed that it would keep them there "for an extended period."

But it can’t cut short term rates further. So the Fed’s focus has shifted to longer-term rates, which are typically set by investors in the bond market.

When demand for bonds is heavy, issuers like the Treasury have an easier time finding investors willing to accept lower interest rates. That’s why massive bond buying by the Fed tends to push those rates lower.

When demand for mortgage bonds collapsed in 2008, the Fed stepped in to keep rates near record lows by spending a trillion dollars as the buyer of last resort. Some Fed members think it’s time for the Fed to resume its government bond-buying to revive growth and head off a worrying slowdown in inflation.

On Tuesday, the FOMC voted to re-invest cash from maturing mortgage bonds back into U.S. Treasuries but stopped short of increasing its overall holdings.

Since the ruinous inflation of the 1970s, the Fed has fought to control it and keep prices from rising too quickly. Now, with the economy weakening — and consumers, businesses and banks hoarding cash — the Fed is confronting the threat of a prolonged bout of declining prices known as deflation.

Though consumers might welcome an occasional price cut, a prolonged period of deflation would wreak havoc on the U.S. economy.

Deflation creates a serious drag on growth because consumers and businesses postpone spending, waiting for prices to fall further. The resulting decline in profits would hurt stocks; falling house prices would further erode home equity. Debts, now repaid with money that increases in value, would become more burdensome. One of the few deflation refuges is cash, which prompts consumers and businesses to spend less, worsening the cycle.

Not seen in the U.S. since the Great Depression, Japan is struggling to break out of a deflationary cycle that has stifled its economy for over a decade.

Debate over the Fed’s response to the threat of deflation intensified last month after St. Louis Fed president James Ballard, a voting member of the FOMC, published a paper warning that the central bank’s current “zero interest rate” policy could be inadvertently pushing the U.S. toward a deflationary vortex.

Most forecasters put the odds of U.S. deflation at less than 50-50. But the risks are so severe, Bullard argued in his paper, that the Fed needs to act now to prevent it from happening — rather than wait until the downward price spiral has taken hold.

“Anybody who has any doubt about how dangerous deflation is should get on a plane and go to Japan,” said El-Erian. “Two things happen when you get into a deflationary trap. One is policy becomes totally ineffective. Second, the politics of deflation are really hard. No one agrees on what to do, because there is no optimal policy solution. So the sooner you get off the road to deflation, the better.”

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