Another Fed Miss
The central bank's latest action did not resolve anything.


David Malpass

The Federal Reserve’s action on Wednesday — a 25 basis point reduction of the overnight interest rate — did not resolve anything. The rate cut, which lowers the federal funds rate to 1 percent, and the statement that accompanied it, still leave a lot of uncertainty floating around. We still don’t know the Fed’s outlook on the economy, nor what policy options it has in its arsenal.

The U.S. economy’s risk-aversion problem remains unchanged. The Fed didn’t help answer a key economic question: When will the businesses that have survived a deflationary recession, especially the small ones, begin to take risks and make investments?

Fortunately, both monetary and fiscal policy are today providing massive stimulus, and the economy will probably grow relatively fast now that the dollar is at a normal level.

Still, the Fed had a chance to help ease a lot of uncertainty, and it let the moment slip away.

The Fed used a new phrase in its statement on Wednesday, codifying the insurance idea floated in recent months: “… a slightly more expansive monetary policy would add further support for an economy which is expected to improve over time.” The concept of an “insurance” rate cut isn’t very reassuring. The Fed is all-powerful in the inflation/deflation arena — it prints money, so it shouldn’t need insurance. Further, the added fluctuations in interest rates caused by insurance operations add another uncertainty to the economic outlook.

The talk of deflation has not built confidence in the economy, nor has it lowered the level of uncertainty. The discussion ignores the change in the value of the dollar in causing deflation in 2000 and stopping it in 2003. A statement from the Fed that the risk of deflation has been eliminated over the last two years by the decline in the dollar would have been better.

Another uncertainty worry relative to the Federal Reserve is that the Fed seems to have lost confidence in its tools for combating deflation. For example, it has apparently rethought the idea of “buying out the yield curve,” or purchasing more Treasury notes and bonds as a way of sending liquidity into the pipeline. This rethinking leaves a vacuum in terms of the theoretical response to deflation.

The Fed, of course, could fill that vacuum with a price-rule monetary policy aimed at price stability. This means a commitment to adding liquidity when the dollar strengthens and subtracting it when the dollar weakens. That would rule out any serious problems with inflation or deflation, helping rebuild confidence.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.


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