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Tuesday, August 10, 2010

The FOMC Decides on a Minor Course Correction

I posted a brief reaction to the FOMC Press Release:

The FOMC Decides on a Minor Course Correction

Update: Paul Krugman reacts:

The Focal-Point Fed: The FOMC has spoken. What’s my reaction? The Fed’s current policy is grossly inadequate, logically bizarre, and slightly — but only slightly — encouraging.

What the FOMC announced was a slight change in policy: rather than allowing its balance sheet to shrink as the mortgage-backed securities it owns mature, it will maintain the balance sheet’s size by reinvesting the proceeds in long-term government bonds. Roughly speaking, it has gone from a completely crazy policy of monetary tightening in the face of massive unemployment and incipient deflation, to a policy of standing pat in the face of same. Whoopee.

And it’s a very strange decision, if you think about it. Presumably there’s some optimal size of the Fed’s balance sheet, given the state and prospects of the economy. What are the odds that the optimal size of that balance sheet is precisely the size it’s currently at? ...

So why freeze the size of the balance sheet right where it is? The answer is that it was, literally, the least the Fed could do. If it had continued to let the balance sheet shrink, the reaction both from Fed critics and from the markets would have been terrible. In effect, reinvesting the funds from expiring securities became a focal point, an essentially arbitrary location in the space of policy responses that nonetheless had come to have “salience”, because it was what everyone was watching.

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

Part of what I said in the link above is that "It's something, and it indicates more awareness of the struggles the economy is having than some recent commentaries from FOMC members would suggest. But more aggressive action -- an actual expansion of the balance sheet -- is needed." So I certainly agree that more expansionary policy is needed, though it's probably hoping against hope for FOMC members to radically change course without external pressure. However, I have to hope anyway -- FOMC meetings are five to six weeks apart -- and pushing policy using a "meeting to Meeting" strategy of constant pressure will take forever, or so it will seem from the perspective of those waiting for an improvement in labor market conditions and hoping that their resources don't run out before they can find another job.

    Posted by on Tuesday, August 10, 2010 at 11:49 AM in Economics, Monetary Policy | Permalink  Comments (63)


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