Sunday, July 15, 2012

The Federal Reserve is Doing Enough...For Now

The economy is recovering.  It is not recovering as fast as we would like, but it is recovering.

Within this recovery there may be only so much that government can do to speed on this recovery.  In my mind, we need to keep this thought in mind when considering what else the Federal Reserve can do at the present time. 

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, I believe that he is not saying much because he has said enough for the time being. 

The market is concerned about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point because he believes that the Fed is doing enough…for now! 

One part of the Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

But, some members of the Federal Reserve’s Open Market Committee are concerned about the weakness that still exists in the economy.

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There are other concerns at work, however.

There is real concern over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.  

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

In terms of the economy, the Fed has done about all it can do right now.  The major thing it has done…at least for the time being…is to stop any cumulative movement in the economy to a period of price deflation.  This is the big theoretical concern that exists in a period like this, the possibility that the economy will decline into a period of debt-deflation.

However, protecting the economy from a period of deflation does not eliminate the problem I discussed earlier this week, the problem of the extensive debt buildup in the economy.  The deleveraging of the economy is still something that needs to take place.

The deleveraging of the economy will still take some time.  For now, I would argue that the Federal Reserve has done and is doing about all it can to keep the expansion going.  The economy is recovering.  It certainly is not recovering as rapidly as we would like it to recover, but it is recovering.  Sometimes only so much can be done to assist a recovery and the rest must be accomplished by letting the system do its own part.  In the current situation, reducing the debt load is what the economy needs to do and it takes time for an economy to achieve this.     

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