Trying to make sense of the Fed

Federal Reserve Chairman Ben Bernanke’s speech in Jackson Hole, Wyo., on Friday revealed the central bank was poised to take further action to help the economy. In what several described as uncharacteristically strong language, Bernanke called continuing high unemployment rate a “grave concern” and indicated the bank was poised to take action to stimulate the lagging economy.

Bernanke said that while the Fed’s monetary policy had helped the economy, it was clear that more action was necessary and that potential gains outweighed the costs of doing so.

Many organizations covering his speech indicated that Bernanke was going to have a harder time selling the benefits of this policy to an increasingly skeptical public. Writing in the Wall Street Journal, Jon Hilsenrath said:

But economists and central bankers wondered more openly than usual if the Fed had the tools to fix the problems of the day and expressed frustration that four years of super low interest rates and extraordinary money-pumping by the Fed hadn’t done more to spur the slow-moving economy.

In a post for the New York Times’ Economix blog, Binyamin Appelbaum wrote that most attendees at the conference agreed the action the Fed was considering wouldn’t do enough to fix the economy.

What more can be done? Well, pretty much everyone here is upset about the breakdown of fiscal policy, which is becoming a principal drag on growth.

Indeed, quite a few attendees regard that as the entire issue. They do not agree on what fiscal policies are needed. (The grab bag includes tax cuts and spending increases, household debt reduction and government debt reduction.) But they do agree that monetary policy has basically done (almost) all that it can.

Appelbaum goes on to write about several options proposed to stimulate the economy including one from Michael Woodford, a Columbia University professor, who said the Fed could lift growth now by indicating it would tolerate inflation in the future after the economy begins to recover.

San Francisco Fed President John Williams, who joined several others in encouraging a plan for open-ended bond-buying was quoted in a Bloomberg News story as saying the program could be larger than QE2.

One of the problems with this plan is that it may not work. As the Wall Street Journal reported:

 The key problem, said University of Chicago professor Amir Sufi, is that households burdened by heavy debt loads aren’t responding to low interest rates by spending more, as typically happens in a crisis. They need to reduce their debt first, he said. “I’m not so convinced that monetary policy can play a big role,” he said.

And that’s the real point. The Fed may not have a lot of options left, but neither to most people. Monetary policy is falling short in terms of fixing the economy. As the Times reported:

Donald L. Kohn, a former Fed vice chairman, asked Saturday why the Fed’s unprecedented efforts so far had produced “so little growth.”

“The fact that we keep trying to bring spending from the future to the present with lower and lower interest rates, are there diminishing returns?” he asked. “There’s a lot we don’t understand and it’s hard to make policy if you don’t.”

It’s likely that markets will give the Fed’s plans a lackluster welcome and will remain volatile going into last quarter of the year. But given the tepid recovery and that the economy continues to limp along, it’s obvious that monetary policy can only go so far to stimulate the economy.