Fed prescribes placebo after wrong diagnosis

When a patient walks into a doctor's office complaining of a chronic condition, the first thing the physician does is take a medical history. When the economy is sick, a correct diagnosis is equally important in determining the course of treatment.

On the fiscal-policy side, the Obama administration and members of Congress can't agree on whether the US economy's problem is too much debt or too much unemployment. At least they agree on the "too much" part.

Central bankers at the Federal Reserve examined the patient and came to a different conclusion about the economy's malaise. At dthe latest policy meeting, Fed officials determined that the problem is the rate structure: Specifically, long-term interest rates are too high. In order to bring them down, some verbal tinkering was in order.

The Fed said economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013". This is the first time since the introduction of the ‘extended period' language in March 2009 that the Fed has assigned a specific time frame to it.

The truth is, the Fed doesn't know how long it will need to keep the funds rate at its current setting of zero to 0.25 per cent.

That's not to say the Fed's projections are worse than those of your average Wall Street economist or average Joe. It's just that the central bank controls the monetary levers. Unlike the rest of us, it has the tools to convert its forecasts into reality.

Wrong moves hurt

At the same time, actions predicated on forecast mistakes have consequences. The Fed was still worried about deflation as late as 2003, leaving the funds rate at 1 per cent for too long and inflating the housing bubble.

From the three options that Fed chairman Ben S. Bernanke outlined previously should the economy need an additional transfusion — additional long-term securities purchases, a reduction in the interest rate paid on excess reserves, and verbal gymnastics — the Fed picked the third, which is also the silliest. And it's right off the shelves of academia, where rational-expectations theory is an obsession.

Bernanke explained the goal of such a strategy in a speech at the Kansas City Fed's annual Jackson Hole conference last year. Modifying the language in the statement "to communicate to investors that it anticipates keeping the target for the federal funds rate low for a longer period than is currently priced in markets" would "presumably lower longer-term rates", he said.

When was the last time you heard a friend complain that high mortgage rates were standing in the way of a home purchase? Last week, the rate on 30-year fixed-rate mortgages was 4.4 per cent. With Treasury yields diving after the Fed's statement, that rate could approach 4 per cent, where it was in November.

The housing market was lifeless then, and there's no reason to expect lower mortgage rates to ignite the residential real- estate market when an overhang of debt is the problem.

The Fed's two-year promise of zero interest rates isn't without consequences. What happens during the next inflation scare? If there is one thing the Fed fears more than actual inflation, it's inflation expectations that break loose from their moorings.

Nor was access to, or the price of, credit an issue for small business. Ninety-two per cent of the respondents in the National Federation of Independent Business's July survey said their credit needs were being met or they weren't interested in borrowing.

Flawed assumption

This is another fixation based on the flawed assumption that the cost of the information the public needs to make an informed decision about future inflation is nil.

Yes, people behave rationally (well, not always). But in many cases they lack the information that would lead to rational behaviour. And there's a cost of acquiring it. My completely unscientific street survey on inflation several years ago convinced me that Fed officials need to leave the ivory tower every so often to test the theories they use in their econometric models.

Some economists suspect that the latest verbal gymnastics are a prelude to some form of renewed action on the part of the Fed. Three members of the policy-making committee, all presidents of Federal Reserve banks, dissented from the Fed's action, or wordplay as the case may be. They preferred to retain the extended-period-without-a- date language.

The last time there were three dissents was on November 17, 1992, according to Ward McCarthy, chief financial economist at Jefferies. That was during another period of low official interest rates (at the time, 3 per cent was considered low), sub- par economic growth (at least before data revisions), modest yet accelerating job creation and record budget deficits ($290 billion).

Back then, the drug of easy money was enough to restore the economy to health. Today's economy would appear to be drug-resistant. More likely, it's suffering from a different and more lethal disease.

— Bloomberg