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Points to Ponder as the Fed Gathers

Posted By J.D. Foster, Ph.D. On August 10, 2010 @ 11:30 am In Economics | Comments Disabled

The Federal Reserve Building [1]

The Federal Reserve’s Open Market Committee meets today in the face of tremendous economic uncertainty. In light of last week’s dismal jobs report [2] and related evidence of a faltering recovery, markets are looking for signs as to what the Fed might say and do. It’s widely expected that the Fed will downgrade its near-term outlook for the economy and will suggest some actions it might take if a severe downturn materialized.

While the attention given to the jobs picture is understandable, some disturbing issues surrounding monetary conditions deserve equal attention. For example, perhaps the best measure of underlying inflationary pressures is an updated version of the trusty old Consumer Price Index (CPI). This more advanced version is called the chain-weighted CPI, or C-CPI. A common technique for looking at underlying trends is to look at core inflation by stripping out movements in food and energy prices. The annualized rate of inflation for the core C-CPI has been exactly 0.0 for the past three months. According to this measure, inflation over the past year has been a minuscule 0.2 percent. In short, it suggests near perfect price stability.

Price stability is generally a wonderful condition but less so in an era of high unemployment. Price stability combined with high unemployment suggests a serious risk of deflation. While inflation is bad, deflation is worse for the simple reason that businesses and workers are highly resistant to accepting lower prices and lower wages. Thus, deflation can generate significant new dislocations in the economy.

Another worrisome development is that the monetary base—the raw material from which the nation’s money supply derives—has fallen over the last six months. Nor is this pattern isolated. The most comprehensive measure of the money supply now in use (called MZM) has fallen 1.9 percent year over year. A contracting money supply does not generally bode well for a growing economy.

There’s no doubt interest rates are very low, with the Fed funds rate at essentially zero and the 10-year Treasury bond rate now well below 3.0. And so by traditional measures it appears superficially as though Fed policy is highly stimulative. Under the surface, however, lurk worrisome signs: Possible deflation and steady declines in both high-powered money and the larger money supply are not signs suggesting a stimulative monetary policy.

So, what might the Fed do in response? The Fed has acquired massive amounts of government and private debt, a lot of which will mature in the coming weeks and months. The Fed could buy more to maintain its current position. This would not be stimulative, but it could eliminate contractionary pressure.

Or the Fed could add to its pile of government and private debt, pumping liquidity directly into credit markets. But if the Fed hopes to drive down interest rates to stimulate the economy this way, one has to wonder why a 2.5 percent long bond yield will be stimulative when a 2.8 percent yield isn’t.

In short, the Fed may have quite the conundrum on its hands. If the recovery is faltering and deflation a risk, then the Fed may not have a lot of good options. And it’s not getting any help from fiscal policy since all that the current leadership knows how to do is borrow and spend, borrow and spend in the forlorn hope that adding to the federal debt can lead to prosperity. If Chairman Bernanke thought the financial crisis was tough. …


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URL to article: http://blog.heritage.org/2010/08/10/points-to-ponder-as-the-fed-gathers/

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[1] Image: http://www.foundry.org/wp-content/uploads/the-fed100224.jpg

[2] dismal jobs report: http://blog.heritage.org../2010/08/06/what-recovery-summer/

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