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All Da King's Men

Fed Chair Responds To Economic Woes

By Da King Published: August 27, 2010

As Recovery Bummer draws to a close, we face more bad news.

From The Associated Press:

The economy grew at a much slower pace this spring than previously estimated, mostly due to the largest surge in imports in 26 years and a slowdown in companies' restocking of goods.

The nation's gross domestic product -- the broadest measure of the economy's output -- grew at a 1.6 percent annual rate in the April-to-June period, the Commerce Department said Friday. That's down from an initial estimate of 2.4 percent last month and much slower than the first quarter's 3.7 percent pace.

The revision follows a week of disappointing economic reports. The housing sector is slumping badly after the expiration of a government homebuyer tax credit. And business spending on big-ticket manufactured items such as machinery and software, an important source of growth earlier this year, is also tapering off.

As a result, most analysts expect the economy will grow at a similarly weak pace for the rest of this year.

"We seem to be in the early stages of what might be called a 'growth recession'," said Ethan Harris, an economist at Bank of America-Merrill Lynch. The economy is likely to keep expanding, but at a snail's pace and without creating many more jobs. Harris expects the nation's output will grow at about a 2 percent pace in the second half of this year. As a result, the jobless rate could rise from its current level of 9.5 percent.

The widening trade deficit subtracted nearly 3.4 percentage points from second quarter growth, the largest hit from a trade imbalance since 1947, the government said.

The economy has grown for four straight quarters, but that growth has averaged only 2.9 percent, a weak pace after such a steep recession. The economy needs to expand at about 3 percent just to keep the unemployment rate from rising.
Economists expect many other supports for economic growth to fade. Federal government spending and the housing sector bolstered the economy last quarter, but housing has slumped again and will likely drag growth down in the third quarter. The impact of the federal government's $862 billion stimulus package is also projected to taper off this year.

There are few other signs of strength. Even business investment is expected to drop, as a report earlier this week showed that business orders for capital goods fell in July.

The sluggish economy led to great anticipation over Federal Reserve Chairman Ben Bernanake's friday morning address. Bernanke discussed what the Fed's actions would be:

To help sustain the economy, Mr. Bernanke gave his strongest indication yet that the Fed was ready to resume its large purchases of longer-term debt if the economy worsened, a move that would add to the Fed’s already substantial holdings.

“I believe that additional purchases of longer-term securities, should the F.O.M.C. choose to take them, would be effective in further easing financial conditions,” Mr. Bernanke told a Fed policy symposium here. He was referring to the Federal Open Market Committee, the panel that sets interest rates, which Mr. Bernanke leads; some members have expressed unease over the prospect of the Fed pursuing any further monetary accommodation.

“Central bankers alone cannot solve the world’s economic problems,” he said.

Bernanke predicted a better economy in 2011, but his record at prediction has not been very good so far.

With interest rates near zero, there isn't too much more the Fed can do to stimulate the economy there. This turns the discussion to more quantitative easing, where the Fed prints more money ex nihilo (backed by nothing), and then uses it to purchase financial assets like bonds and mortgage-backed securities. It's a bad option (not that there are any good options), because printing more money devalues the dollar. The risk with quantitative easing is that too much easing can cause serious inflation. Because we're in a deflationary period now, that probably isn't an immediate risk, but it could become one down the road.

Purchasing these assets is hoped to free up more investment capital, which in turn will stimulate job creation. (It would also help if the dummy in the White House wasn't poised to raise capital gains taxes on investment at the same time the Fed is trying to spur investment for job creation. Lowering our non-competitive business tax rate of 35% would be another good idea for job creation).

The Federal Reserve has already accumulated an unprecedented amount of assets and liabilities on it's balance sheet since the recession started. The Pete Peterson Foundation has the numbers, and offers an analysis:

In July 2007, before the financial crisis began, the Federal Reserve held about $900 billion in assets, of which U.S. Treasuries accounted for about $790 billion. By the end of 2008, at the height of the crisis, the value of the Fed’s assets had grown to about $2.275 trillion, an increase of nearly 300 percent. At the end of 2009, the total value of the central bank’s assets remained essentially the same as they had been at the end of 2008.

The Federal Reserve's response to the financial crisis is projected to have positive near term impacts on the federal budget and potentially longer lasting impacts on the economy. In a recent New York Times article, economists Alan Blinder and Mark Zandi assert that the Fed's role helped mitigate the economic impacts (higher unemployment rates and deflation) from the financial crisis. In addition to higher remittances to Treasury over the next few years, the Fed's actions have led to low interest rates. As a result of the Fed's purchases of debt in the open market, demand increases and interest rates decrease on everything from mortgages to loans for small businesses. Additionally, by pumping so much money into the economy at a time of weak demand and widespread deleveraging, the Fed has helped to stave off deflation, creating the kind of price stability that has prevented the economy from entering a severe depression. The Fed’s decision to buy trillions of dollars of mortgage-backed securities has helped stabilize housing prices at a time when a weak economy and oversupply of houses threatens to send prices even lower.

Of course, all of these actions come with a risk, and with a reasonable concern about the new role of the Federal Reserve. Instead of merely supervising financial markets, the Fed is now a key participant (the key participant, some would argue) in markets. Now that the Fed is so intertwined with the financial system, it may face "exit strategy" issues: if it pulls out of markets too quickly, it threatens to create deflation, leading to another decline in the economy; if, on the other hand, it pulls out too slowly, the economy is at risk of hyperinflation that would destroy the value of savings and place a hardship on Americans.

In summary - hold on, it's going to be a long bumpy ride.



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