Federal Reserve System: Five Reasons Why The Fed Should Not Decrease Stimulus In September

Analysis

 @JosephLazzaro
on July 18 2013 4:09 PM
  • Bernanke 2012
    U.S. Federal Reserve Chairman Ben Bernanke is being pressured by some economists to decrease quantitative easing this year. But is the U.S. economy strong enough to justify that action? Reuters
  • Bernanke Hill 17July2013
    Ben Bernanke Reuters
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The job sector of the U.S. economy appears to be gaining some traction, and lo and behold what does one hear yonder?

A hue-and-cry, particularly among conservative economists and voters, calling for the U.S. Federal Reserve to begin to decrease its quantitative easing program – currently $85 billion in monthly bond purchases.

Well, the analysis forwarded here argues the above conservative critics of quantitative easing were wrong about the start of program (they opposed it), wrong about its impact (it’s working), and they’re wrong about it now. (September is not the optimal time to start tapering the program.)

Moreover, the conservative critics have short - or at least convenient - memories. They forget that the Fed’s intervention, in conjunction with its fellow central banks around the world, prevented the financial crisis from turning into a catastrophe - a possible collapse of the global financial system, and certainly the collapse of the U.S. financial system.

On the U.S. side, the Fed’s intervention kept credit markets liquid, restored vital banker-to-banker trust, and maintained systemically critical institutions (including AIG), in what may have been the most successful public policy intervention since the Great Depression. Hindsight is always 20-20, but don’t let anyone fool you. The Fed’s effort, in conjunction with the efforts of other central banks, averted a global calamity. To be sure, it has not been a perfect intervention -- but the major battle has been won: The world averted reverting to the barter system. And your ATM has worked properly every day.

Hence, it goes without saying that the conservative critics who still think it's 1913, not 2013, are wrong about reducing quantitative easing in September. Here’s why: 

1 – Job growth

True, job growth has picked up in recent months – to an average of 190,000 new jobs per month.

However, the reality is that we’re four years into the recovery but we are nowhere near full employment. The United States is still short about 11.8 million jobs, if one only counts the officially unemployed. If one includes all adults who want a full-time job, but who aren’t officially “counted” as being unemployed, the job shortage is 18.4 million. That’s an enormous job deficit. Hence, until the nation is generating 250,000 and 300,00 new jobs per month, for many months, it isn’t prudent for the Federal Reserve to even consider decreasing quantitative easing stimulus.

2 - Sequestration

Yes, that funny, Latinate term is another reason for the Fed to delay decreasing quantitative easing.

In the best of all possible worlds, the public sector -- particularly at the federal level -- would be adding to GDP growth. It’s a classic Keynesian economic prescription that has worked for generations. Do you need an aircraft carrier? Congress appropriates $4 billion to $6.2 billion and presto: Two years later the nation has another aircraft carrier.

The same can be said of efforts to rebuild our infrastructure, schools/universities, hospitals, Internet network, electric grid, etc. Congress could have appropriated additional funds for all of the above, and added to U.S. GDP growth. But nooooooooo, to cite the late, great actor John Belushi, Congress, tied into knots by the tea party-dominated Republican Party, has cut spending, called sequestration. To be sure, a balanced federal budget, long-term, is the correct policy, but to cut too much spending too soon, and amid a modest recovery, is flat out wrong. Had Congress provided an additional $500 billion to $750 billion in stimulus, U.S. GDP growth would be much larger, as would job growth.

The impact of sequestration on the Fed is obvious enough: The public sector is actually contracting, even as the private sector expands, and without that booster from the public sector – the result has been a fragile economic recovery. Hence, the Fed has to maintain stimulus for longer, because Congress did not do its job.   

3 – Frugal Consumer

Also, a “frugal consumer” era has taken hold in the United States. In general, U.S. consumers are watching discretionary dollars more carefully, and trading down in brands, when possible. Others have radically reduced their consumption habits. And overall, the U.S.'s aging population means that fewer dollars will be dedicated to optional purchases.

The bottom line? U.S. consumer spending, historically about 65 percent of GDP, will not represent as large a portion of the economic pie as it did in the past.

The significance of the above for the Fed? That great engine of U.S. economic growth -- the U.S. consumer -- can’t be counted on to generate 4 percent to 6 percent GDP growth. The U.S. economy will need other engines of growth (new technologies/innovation, new sectors, exports) to increase GDP growth to an acceptable level, and these, as the Fed knows, take time to develop. Hence, quantitative easing must be deployed for a longer time.

4 – Europe, Japan, China

Rarely, if ever, does one cite an international reason to justify Fed policy, but given the postmodern era’s globalization of economics, it’s valid.

Simply, the United States cannot count on economic demand in Europe, Japan or China to stimulate the U.S. economy.

Europe is still dealing with its debt crisis and structural reforms, Japan, with an aging population, is trying to get to 2 percent GDP growth, and China to date has not provided enough demand to U.S. markets. In other words, the world’s two other major economic regions, outside China, are not growing at robust rates.

Hence, with the above as context, the Fed knows that it must do everything within its power to generate domestic demand: It may be the only source of U.S. GDP growth! And that means extending quantitative easing well beyond September.

5 – Inflation? What Inflation?

Finally, there’s inflation in the United States. Or the lack thereof.  The core Personal Consumption Expenditure price index (PCE), the rate the Fed follows closely, is up just 1.05 percent in the past 12 months!

In short, Glenn Beck was wrong: Hyper-inflation did not follow the Fed’s quantitative easing program, and if anything, the Fed’s main concern -- and the biggest threat to the U.S. economy -- is deflation, not inflation. Inflation is bad, but deflation is worse.

Deflation, a protracted, systematic decline in prices, robs companies of revenue and can lead to the dreaded ‘deflationary spiral,’ in which price cuts lead to lower corporate revenue, prompting more layoffs, leading to further consumer spending declines, prompting more price cuts, and so on. Hence, deflation would hurt most corporations’ top lines, and that would weigh on job creation, the economy, and eventually, the stock market.

Hence, with inflation so low, the primary threat to Fed stimulus policy is not a threat, at this time. Given stable prices, the Fed can focus on helping get the United States back to maximum employment -- and that means maintaining quantitative easing well into 2014. 

Patience And Time

U.S. job growth is at a fair level, but the nation is still short at least 12 million jobs. The public sector, due to sequestration, is actually reducing GDP, not increasing it, with accompanying public sector layoffs. The U.S. consumer appears to have entered a new era: out with going into debt to buy nearly everything, in with focusing on quality-of-life activities, not shopping until you drop. Europe and Asia won’t help the U.S. economic recovery that much. And hyper-inflation? It has not appeared. 

All of the above suggests a modest economic recovery with stable prices, with not nearly enough jobs for all adult Americans who want full-time work.

Given current economic conditions, the Fed should not consider decreasing its quantitative easing program until June 2014, at the earliest. Patience is a virtue. It’s also the key to maximum employment.

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