'We're Flying Blind,' Admits Federal Reserve President

by Gary North
GaryNorth.com

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Eric S. Rosengren, the president of the Boston Federal Reserve Bank, recently gave a speech at Babson College on November 1. That was a good place to give it. Founder Roger Babson in September, 1929, warned of a stock market crash. Wikipedia reports: "On September 5, 1929, he gave a speech saying, "Sooner or later a crash is coming, and it may be terrific." Later that day the stock market declined by about 3%. This became known as the "Babson Break". The Wall Street Crash of 1929 and the Great Depression soon followed."

Dr. Rosengren began:

Today I plan to highlight three main points about the economic outlook. I always like to emphasize that my remarks represent my views, not necessarily those of my colleagues on the Federal Open Market Committee or at the Board of Governors.

A first point is this: while it is still early to gauge the full impact of the Federal Reserve's September monetary policy committee decision to begin an open-ended mortgage-backed security purchase program, the program has so far worked as expected. The initial response in financial markets was larger than many expected. Given that our conventional monetary tool, the fed funds rate, has hit its lower bound of zero, we have turned to unconventional monetary policy. By that I mean policy that attempts to affect long-term interest rates directly, via asset purchases, rather than indirectly by setting the short-term interest rate, as in conventional policy.

Translation: "Federal Reserve policy has not been working for three years. The FedFunds rate is just above zero. That is because commercial banks have $1.4 trillion at the FED in excess reserves. So, the FedFunds rate is just over zero. In the good old days, the FED pumped in money to get this rate down. These days, it stays down, no matter what FED policy is. So, we had to target another rate. Otherwise, the investing public would conclude that the FED is impotent – kind of like the Bank of Japan has been since 1990."

Unconventional policy has affected financial markets much like movements of conventional policy would have. Our use of unconventional policy tools has led to lower longer-term interest rates; higher equity prices; and, in a peripheral by-product of lower U.S. rates, exchange-rate effects.

Translation: "Believe me. Rates fell. Here is the proof. On September 12, the 30-year T-bond rate was 2.92%. On September 13, the FOMC announced QE3. The rate went to 2.95% by the close of the day. It was at 3.09% On September 14. But ignore that. On November 1, it was 2.89%. See? It was way down: three one-hundredths of a percent.

"So, the policy had no measurable effect on long-term T-bond rates. But so what? We want you to think that we are on top of things, steering the economy in the right direction."

He bragged that the policy had goosed the bond market. It hadn't. He said that it goosed the stock market. For a while, yes.

Is it the FED's job to manipulate the stock market? It appears so. Otherwise, why take credit for it?

By further easing financial conditions, the Fed's actions appear to be providing additional stimulus to the household sector – as witnessed recently by higher consumer confidence, and increases in purchases of interest-sensitive items such as new homes and cars.

What was the cause? How do we know? He was bluffing. For one thing, the FED's monetary base shrank for three weeks after the press release. In early November, it was still below what it was on September 13.

The FED president seemed unaware of all this. But he marched forward, oblivious.

Certainly, concerns about such issues as the looming "fiscal cliff" in the U.S. and slow growth in many developed countries do appear to be depressing business spending. Still, our actions are likely to spur faster economic growth than we would have had without this additional stimulus – and, as you know, economic growth has been painfully slow.

This is a statement of Keynesian faith in the face of policies that have not produced much success in four years.

My second point is that the increased quantity of bank reserves that resulted from these unconventional monetary policy actions have not resulted in inflation above our 2 percent target.

Translation: "Banks are not lending. Businesses are not borrowing. The economy is stagnant. The M1 multiplier remains flat. So, consumer prices are flat. That is what economic stagnation does in recessions and weak recoveries."

The statement issued after our last policy meeting highlighted that we expect to continue the asset purchase program until the economy experiences significant improvement in labor market conditions. How forcefully and how long to pursue asset purchases is complicated – by the uncertainty surrounding the effects of unconventional policies; by the usual difficulty in assessing progress toward our dual mandate (given the sometimes noisy signals of both inflationary pressure and labor market conditions); and by the reality that the amount of stimulus provided by our asset purchases depends in part on market participants' assessment of the likely size of the asset purchase program.

Translation: "We have no idea when these policies will reduce unemployment. Your guess is as good as ours. But we get paid for our guesses. You don't."

The last complication is the result of the open-ended asset purchase program, since it does not entail a fixed amount or duration of purchases; in this respect it is more like conventional policy in the past.

Translation: "This can go on for years. Who is to say how long?"

In fact, the decision of when to stop easing during a recovery is a complicated matter even in more normal times, when pursuing conventional monetary policy through changes in the federal funds rate.

Translation: "FedFunds manipulation rate no longer works. We are flying blind."

Given that the current inflation rate is quite low and is expected to stay low for several years, we have the flexibility to push for more improvement in labor markets than if inflation were not so subdued. My own personal assessment is that as long as inflation and inflation expectations are expected to remain well-behaved in the medium term, we should continue to forcefully pursue asset purchases at least until the national unemployment rate falls below 7.25 percent and then assess the situation.

Translation: "What will policy be after it hits 7.24%? Your guess is as good as ours."

I think of this number as a threshold, not as a trigger – and the distinction is important. I think of a trigger as a set of conditions that necessarily imply a change in policy. A threshold, unlike a trigger, does not necessarily precipitate a change in policy.

Translation: "We will conduct a study. Yes, my friends, a study. Trust me."

Instead, I think of my proposed threshold as follows. Once the unemployment rate declines to this level, we would undertake a full assessment of labor market conditions and inflationary pressures to determine whether further asset purchases are consistent with the desired trajectory for reaching our inflation and unemployment mandates in the medium term. Thus, a threshold precipitates a discussion and a more thorough assessment of appropriate policy, versus a trigger which starts a change in policy.

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November 7, 2012

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 31-volume series, An Economic Commentary on the Bible.

Copyright © 2012 Gary North

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