In Search of Certainty at the Fed
Our monetary PhDs need to get on the same page about policy.


Donald L. Luskin

The Federal Reserve is increasingly becoming a costly source of uncertainty for an economy that already has more than enough to worry about. Things get worse every time the Fed opens its collective mouth. That might be why there’s a new seasonal influence in stock prices: Now when the FOMC meets, stocks go into a big correction. (See chart.)

Chairman Ben Bernanke correctly admits that economic prospects are “unusually uncertain.” It has been a year since the U.S. economy bottomed. By this point in every other post-war recovery, real GDP has rebounded to a new all-time high, with the strongest rebounds following the deepest recessions. But not this time: We’ve now experienced both the deepest recession and the weakest recovery in the post-war period.

Meanwhile, the Fed has ventured into terra incognita. The Fed now operates a near $2.4 trillion balance sheet, holding the toxic assets of AIG and Bear Stearns and about 20 percent of the agency mortgage pass-through market — essentially all of this funded with borrowed money. It’s the biggest leveraged hedge fund in history, and it’s being run by a committee of economics professors.

Of the five Fed governors and twelve regional Fed presidents, eleven have PhDs in economics, and nine have taught economics at the college level. If economics is a science, you’d hope all these scientists could agree on the facts, agree on how to proceed, and explain their conclusions clearly to the rest of us. But this is hardly the case. Instead, their bickering and inability to speak with shared conviction is eroding confidence.

Consider the Fed’s core strategy since it lowered the fed funds rate to near-zero in December 2008. Back then, the FOMC announced that the rock-bottom rate would be maintained “for some time,” and it repeated this promise at its next meeting. After that, the language was adjusted to “for an extended period,” where it has held through this month’s meeting.

And why was this language employed? To reduce uncertainty. Bernanke, who got his doctorate at MIT and once chaired the economics department at Princeton, explained it in a November 2002 speech: By assuring the bond market that the funds rate will not unexpectedly be hiked, yields farther out on the Treasury yield curve will come down since long-term yields are, in large part, the sum of expected short-term yields. So certainty and predictability are at the core of this scheme, enabling the Fed to fight deflation by lowering long-term rates even when the short-term rate is stuck at zero.

So now, with the economy weakening, Bernanke wants to strengthen the “extended period” language — and up the ante in the battle against uncertainty — by guaranteeing the “extended period” will last for, say, one year at least. In Senate testimony several weeks ago, this was first among equals on Bernanke’s list of remedies for a faltering economy.

But here’s the problem: Bernanke’s strategy for creating certainty is itself being subjected to uncertainty.

Enter St. Louis Fed president James Bullard, who received a doctorate from Indiana University and taught at Washington University. In a paper released days before the August FOMC meeting, Bullard called the ongoing zero-interest-rate policy a “peril.” In doing so, he argued that a similar Bank of Japan policy was responsible for that country’s lost decade of deflation.


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