Sudden Discomfort

Minutes of the January 29-30 meeting of the Federal Open Market Committee showed a growing discomfort with the Fed’s Large-Scale Asset Purchase program (QE3). That’s not all that surprising. Even those who strongly favor the program aren’t exactly happy with it. However, that’s a far cry from wanting to end the program anytime soon. We should learn more this week as Fed Chairman Bernanke delivers his semiannual monetary policy testimony (Tuesday and Wednesday).

The FOMC minutes showed that officials remain focused on the labor market. The unemployment rate and a number of other indicators, such as the share of long-term unemployed and the number of people working part time for economic reasons, “suggested that the recovery in the labor market was far from complete.” While there is some debate about whether the weak job market reflects structural or cyclical forces, the Fed sees weak demand as the primary factor restraining job growth. “Several” Fed officials “expressed concern that continuation of only slow job growth and persistently high long-duration unemployment could lead to permanent damage to the labor market.” Most worried that, “should the economy continue to operate below potential for too long, reduced investment and underutilization of labor could further undermine the growth of potential output over time.”

Amid a discussion of the benefits and costs of asset purchases, “most” Fed officials viewed QE3 as “effective in easing financial conditions and helping stimulate economic activity.” Many pointed to the support that low longer-term interest rates had provided to housing and consumer durables. However, “many participants also expressed some concerns about potential costs and risks arising from further asset purchases. ” Several discussed the possible complications in unwinding policy accommodation. A few mentioned the prospect of inflation risks. Some noted that further asset purchases could “foster market behavior that could undermine financial stability.” However, a couple of other participants noted there had been little evidence of that. Nevertheless, to better assess the asset purchase program, the Fed’s staff was asked for additional analysis ahead of future policy meetings.

“Several” FOMC meeting participants “emphasized that the Committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved.” Several others “argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market had occurred.” A few noted “examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability.”

Unsurprisingly, Fed officials range widely in their opinions about QE3. In his Congressional testimony, Chairman Bernanke will present the views of the FOMC, not his own. There may be a lot to sift through (and the markets don’t do “nuance” well). However, while “many” (suggesting a majority of policymakers) are concerned about the potential costs and risks of QE3, Fed officials are also mostly in favor of continuing the program.

How might fiscal policy interfere with monetary policy? The increase in the payroll tax appears to be dampening the pace of consumer spending growth near term, as expected. The sequester, assuming it’s not postponed again, is set to shave 0.5 to 1.0 percentage point from GDP growth this year. Exceptionally accommodative monetary policy will help offset some of the damage of contractionary fiscal policy.

The fiscal/monetary policy interactions get more complicated over time. Apaperwritten by former Fed Governor Frederic Mishkin and others for last week’s U.S. Monetary Policy Forum painted a troublesome long-term outlook. Specifically, Mishkin et al. concluded that countries with a high debt-to-GDP ratio “are always vulnerable to an adverse feedback loop in which high debt leads to higher interest rates and hence higher debt loads, culminating in a tipping point – or fiscal crunch – in which interest rates shoot up.” Such a phenomenon has appeared in the euro area crisis. The authors fear that the problems facing the U.S. in the next decade “could easily escalate into an unmanageable situation.” Tighter monetary policy (that is, higher interest rates) would make fiscal consolidation harder to achieve, and an out-of-control fiscal expansion would create a situation where the Fed could not contain inflation.

Scary stuff, but Fed GovernorJerome Powelldisagrees. In reviewing the Mishkin et al. paper, Powell agreed that the current fiscal path is unsustainable (nobody disputes that), the central bank could ultimately be forced to choose between higher inflation and letting the government default, and the process of normalizing the size and composition of the Fed’s balance sheet “poses significant uncertainties and challenges” for the central bank. The Mishkin paper sets a scenario of a vicious cycle of rising inflation expectations, increasing interest rates, and ever greater fiscal unsustainably – where the Fed become powerless. Powell sees this proposition as “highly unlikely, and at a minimum, premature.” He noted that “terribly difficult fiscal adjustments lie ahead.” However, “the market has every reason to believe that the U.S. will continue the difficult task of fiscal consolidation until the job is done.” He added that the problem is “not principally one of economics or fiscal policy; it is one of governance.”

© Raymond James

© Raymond James

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