Why is the Fed unwilling to do more to help the economy?:
A toxic toolkit, by Greg Ip, Free Exchange: Asked Wednesday what he’d do if the economy needed more stimulus, Ben Bernanke was noncommittal: “We are going to continue to monitor the economy closely and continue to evaluate the alternatives that we have.”
Mark Thoma (here and here) is dismayed that Mr Bernanke, given the time the Fed has had to study this, doesn’t seem to know what he’ll do. Robin Harding says Mark is unfair: what Mr Bernanke does will depend on what happens, and then on developing a consensus with his colleagues.
Mr Harding is right that what the Fed would do differs depending on whether it faces a liquidity crisis or a shortfall in aggregate demand and rising threat of deflation. Yet Mr Thoma is also right that this does not exonerate Mr Bernanke. That he knows what to do in a liquidity crisis ... is of small comfort since such a crisis is not in anyone’s forecast. To echo Mr Thoma, the question is, how will you deal with the plausible forecast of inadequate demand, disturbingly high unemployment and low inflation bordering on deflation? That the Fed has a plan for when another fire breaks out on its drilling rig is fine, but where's the plan for capping the well that's already spewing oil into the ocean?
I think the reasons for Mr Bernanke’s reticence are twofold. First, he’s genuinely optimistic the economy will be okay, in part because he’s sanguine about the expiration of fiscal stimulus.
If it becomes clear ... that that optimism is misplaced, I think the Fed will swing into action quite quickly. ... Only a minority of FOMC members are opposed to more quantitative easing (QE), but because they’re so vocal, it gives the impression of more opposition than really exists. ...
The Fed is not helpless; it has two powerful tools left—but both are politically toxic. One is unsterilized foreign exchange intervention: buying foreign currencies with newly printed dollars... This would both stimulate net exports by pushing down the nominal value of the dollar, and alleviate deflation pressure by pushing up the price of tradable goods. ... But the Fed won't do this without the Treasury’s approval, which for its part doesn't want the rest of the world accusing it of exporting its deflation.
The other tool is a money-financed fiscal expansion..., buying newly issued bonds specifically to enable the federal government to spend more money would be a powerful boost to demand. But this needs the federal government to agree to a lot more fiscal stimulus and the Fed to set aside concerns about being the Treasury’s hand maiden. Neither looks likely.
Mr Bernanke described both those options as hypothetical in his famous 2002 speech on deflation. Eight years later, it’s apparent they are just that: hypothetical.