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Thursday, July 22, 2010

Am I Being Unfair to the Fed, or is the Fed Being Unfair to Those Who Need Its Help?

Robin Harding at the Financial Times blog Money-Supply says I'm being unfair:

Why the Fed’s options are still under review, by Robin Harding: In his testimony today Ben Bernanke said that the Fed has not yet decided on its leading option in the event that it has to ease policy further. Mark Thoma asks, why?

After all this time, and after all the calls for the Fed to do more, they don’t even know what the leading options are? Bernanke says they are prepared to do more if conditions warrant it, but if there was a sudden disruption in financial markets tomorrow, they wouldn’t even know which policy option to prefer. I expected better than this from Bernanke and the rest of the Fed.

I don’t think that’s fair. I think the Fed knows exactly what it would do if there was a sudden disruption in financial markets tomorrow: liquidity programs like those we saw during the crisis and then probably asset purchases if they didn’t work.

I think the Fed is still pondering for a few reasons. First, the best response would depend on the conditions at the time, e.g. asset purchases will deliver better results if markets are stressed and the effect of communications will depend on the yield curve.

Second, the FOMC is quite split about the effectiveness of asset purchases, how much they distort markets, and the risks to the Fed’s credibility. Those debates are reasonable enough. It’s hard to expect a consensus to form unless it has to, because the Fed has decided to act (whether it should already be acting is a separate debate).

Third, I think the Fed is keen to keep revisiting all possible options, including those it has decided against in the past. That seems healthy enough to me.

I'll accept that the Fed may know what it would do if financial markets have a sudden breakdown tomorrow, but I'm not sure they know "exactly" what to do. That requires that they've worked out the uncertainties that plagued them the first time they faced a sudden financial crisis, and I don't think we know for sure that they have. But the point is that what the Fed needs to do in the case of a sudden financial disruption is different from what it needs to do to give a boost to an economy struggling to recover, and that they can know one without knowing the other. That's fair. But isn't it also fair to expect the Fed to be prepared for both?

So I don't accept that the Fed should not know what its best option is for dealing with the situation as it exists today. The first rationale for this given above, that the best response is state dependent (i.e. that it will depend upon the conditions at the time), is not an excuse for waiting to figure out what to do. If the Fed faces different possible future outcomes, then it should develop state contingent policy responses, i.e. it should know what it will do under all of the future scenarios it can imagine. It's a mistake to wait until you know what the conditions are before starting to figure out what to do. Instead, there should be a plan that says what the best response is to a variety of potential future states of the economy. A black swan could always appear and that would require policy to be developed on the fly, but the response to most potential future economic conditions should already be known.

The second objection, that the Fed is split, is not a very compelling excuse either. Policy splits are common, nothing new there. Take a vote or institute a process for resolving this. Better to get the disputes resolved now than trying to resolve them in the middle of a crisis when quick action is needed. The third excuse is that the Fed may discover a better policy as it revisits its options. The Fed should revisit its options, no disagreement there, and if a better option presents itself later, the Fed should certainly adopt it. But how does that stop the Fed from making the best choice given what it knows right now? There's always the possibility of finding a better solution in the future, and the Fed shouldn't stop trying to improve, but it should also know what the best options are given present conditions. Being able to say what they'd do if they had to act today doesn't seem to be too much to ask.

So the answer I expected from Bernanke was something like, "while we continue to try to fine-tune and improve policy, as always, we are fully prepared to react to a wide variety of future conditions, and could act today if we thought we needed to do so."

What this really says, to me anyway, is that the Fed does not believe conditions are bad enough right now, or can possibly get bad enough in the near future, to make the Fed feel the need to be ready to act. It also says that six months ago, or however long it takes to figure this out, they were convinced that the economy would not need more help today, so there was no need to be ready. But how did they know then that they wouldn't want to act today? Members of the Fed think they have plenty of time yet to weigh their options carefully, and in the unlikely event things really do get worse, measurably worse than they are now, then they'll figure out what to do. But, apparently there's no rush.

That they haven't even felt the need to be ready to react to conditions like we are seeing today -- unemployment staying persistently high, deflation month after month, and so on, conditions worse than the Fed expected six months ago -- is the disappointing part. The main problem I have with the Fed's position is that they haven't told us what they are so worried about if they do act now. Is it inflation? Even after recent data showing deflation? Is it credibility? The Fed has an obligation to address both inflation and unemployment, and it's a mistake to base their credibility on just one component of its dual mandate. The Fed is losing credibility with the public daily, and its not because of worries over inflation. They've tossed out a variety of possibilities regarding the things they are worried about, but the specifics have been lacking.

What, exactly is the cost if they do act now? Until the Fed has a good answer to that question, and so far I haven't heard it, I will continue to wonder not only why they aren't ready to act now, which is bad enough, but why they haven't tried to do more to help an economy that is clearly struggling. We're in danger of a lost decade or worse, and the Fed is not responding adequately to that threat.

    Posted by on Thursday, July 22, 2010 at 12:24 AM in Economics, Monetary Policy | Permalink  Comments (40)


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