Fed Rescue Effort for Economy Would Carry Risks

(Oct. 15) -- The straggling jobs market, foreclosure epidemic and rash of vulnerabilities across the American economy seem to call for a rescue effort from the Federal Reserve, but any such rescue bid would come with risks of its own.

Fed Chairman Ben Bernanke today made the case for additional economic aid, arguing that high unemployment and low inflation could be treated by buying large amounts of Treasury securities. Such so-called quantitative easing is a way for the Fed to inject huge amounts of cash into the credit markets and push down long-term interest rates.

Bernanke noted the policy-making Federal Open Market Committee sees potential perils in returning to a tool it first wielded in late 2008 to fight the financial crisis. Still, he said in a speech at the Federal Reserve Bank of Boston, "there would appear -- all else being equal -- to be a case for further action."

That was as unequivocal as Bernanke got, yet his statement was being read by markets, most economists and the financial news media as the clearest signal yet that at the Fed's next meeting in November, it will announce plans to expand its portfolio of longer-term Treasurys.

Bernanke said a "disadvantage" of such bond buying "is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public."

"These factors have dictated that the FOMC proceed with some caution," Bernanke added, a caveat he has included since he began in August to hold out the prospect of new quantitative easing.

If Bernanke has increasingly appeared to think the time for caution is over, some of his colleagues on the committee may not agree.

Plenty of Pain

The problem for Bernanke & Co. is that the economic recovery that began in July 2009 and appeared to accelerate a bit less than a year ago -- thanks in part to government stimulus spending and near-zero Fed interest rates -- didn't build enough momentum to pick up speed on its own.

Bernanke insisted today that a move to a self-sustaining recovery is under way, but it has been held back by tepid consumer and business spending, the flailing housing market and "the painfully slow recovery in the labor market."

Moreover, if current economic conditions persist, the Fed doesn't expect job creation to get much stronger in 2011, which means "prolonged high unemployment [that] would pose a risk to consumer spending and hence to the sustainability of the recovery."

The other big worry for Bernanke is inflation, or the lack thereof.

From the late 1960s until about a decade ago, reining in inflation was the greatest challenge of the Fed. But since 2003 -- when Alan Greenspan's Fed first voiced "disinflation" worries in light of Japan's woes in the 1990s -- the central bank has been on guard against the possibility in weak economic times that prices could spiral lower and discourage people and companies from spending.

Inflation has been slowing in recent months to the point where economists over the summer began to worry about deflation, and the consumer price index released today by the Labor Department didn't provide comfort.

Consumer prices rose at a seasonally adjusted rate of 0.1 percent in September from August, and they were up just 1.1 percent from September of last year.

Even that minor blip was only because the cost of food shot higher last month, while gasoline and other energy prices got even more expensive. Stripping out volatile food and energy costs, the core CPI didn't change at all in September, or in August either.

The Fed considers a healthy, sustainable annual inflation rate to be about 2 percent, and Bernanke today called the current price growth "too low" for the Fed's comfort and a level that suggests "the risk of deflation is higher than desirable."

This, Bernanke said, makes the "a case for further action."

Unintended Consequences

The Fed would find it much easier to ignite new hiring and give a fillip to consumer prices if it hadn't already exhausted its primary tool for lowering the cost of borrowed money. The Fed's benchmark short-term interest rate has been targeted at zero to 0.25 percent since the peak of the financial crisis in December 2008.

When even that wasn't enough, the Fed launched its first round of quantitative easing -- the purchases of both Treasurys and mortgage-backed bonds -- and after declaring it a success, the Fed stopped making those purchases late last year and in the first months of 2010.

But though the Fed is now prepared to do it again to fight unemployment and stoke some inflation, the economy is in a very different place.

The output of U.S. businesses is indeed growing, and jobs are being created, just not fast enough to keep pace with the number of people finishing school and joining the pool of aspiring workers -- or to put back to work the millions of Americans who lost their job in the recession.

September retail sales, reported by the Commerce Department today, came in stronger than expected at 0.6 percent greater than they were in August and up 7.3 percent from September 2009 -- evidence consumers aren't retreating.

And some Fed officials -- including Kansas City Fed President Thomas Hoenig -- have been arguing the Fed's current open-ended promise of near-zero rates risks stoking inflation.

On one front, he's already right.

Uncertainty Principles

Since Bernanke started talking about making more dollars available, the U.S. currency has been plummeting against the euro, the yen and other currencies. That's one reason oil and gas prices have been rising.

Though gas is excluded when the Fed concentrates on those core consumer prices, it is not excluded by American consumers when they get into their cars and drive to the mall to go shopping, or businesses when they calculate the costs of shipping their goods and how much money that leaves them to hire new workers.

Another problem for Bernanke is that psychology affects the economy as much as supply and demand.

Consumers are frightened, and according to the latest survey of consumer confidence from the Conference Board, they're increasingly pessimistic about their economic future.

Executives are equally pessimistic and have been increasingly cautious about hiring. Much of the hiring gains this year came in the form of temp jobs because businesses are afraid of long-term commitments.

Though stock markets rose after Bernanke's previous suggestions about new action, they were mixed today, which could indicate there's a lot of uncertainty about whether new Fed moves would succeed.

Which poses another worry for Bernanke: What if any new Fed action doesn't help? What happens then?