Will the Fed kill off the recovery when it takes its foot off the gas pedal?
BY: LYNN O. MICHAELIS
Probably no other issue has received more headlines in the financial press over the last nine months than the likely course of Federal Reserve (Fed) actions. When and how will the Federal Reserve reverse the extremely accommodative stance it began in 2008? The ramifications of a boost in interest rates to financial markets, overall growth and housing starts are the central themes. As a student of the Great Depression, Chairman Bernanke did not feel the Fed should be too cautious in 2008. He also knew the Fed should not reverse the course too quickly. He pointed out that in 1937 the Fed raised reserve requirements, fearing the excessive reserves in the banking system would lead to inflation. Those actions nipped a budding recovery and sent the economy back into recession.
Under Chairman Bernanke, the Fed also tried to improve communication with the financial markets through “forward guidance” in order to reduce financial market volatility. Chairman Greenspan was the master of concealing what the Fed might choose to do. His goals and the reason for his actions were never clear. Critics of Greenspan felt that he was overly concerned with what happened on Wall Street and that he took aggressive action after each stock market correction—lovingly called the “Greenspan Put.” These same critics feel his bias to the financial markets helped create the excesses in the financial system that eventually led to the financial market collapse in 2008.
Since 2008, the Fed has focused on healing the financial system and getting the overall economic recovery on solid footing. After cutting short-term interest rates to zero proved inadequate, the Fed launched a new policy of buying long-term government bonds and mortgage- backed securities, called Quantitative Easing (QE). The assets held by the Fed surged from a mere $500 billion in 2007 to over $4 trillion in 2014.
These purchases boosted excess reserves in the banking system by nearly the same amount. Economists call these excess reserves high-powered money, since each dollar of reserves can lead to an even larger increase in credit.
If the Fed loses control of that credit expansion, then rapid economic growth, tighter labor markets, and rising wages will eventually lead to higher inflation. Some critics feel the Fed is being too slow to act. There are a few members of the Fed Board that feel they should be boosting interest rates now.
Forward Guidance: Guideposts for Fed Action Have Shifted
As part of “forward guidance,” the Fed identified a set of potential factors that could trigger the change in policy actions. A mixture of unemployment and inflation numbers were set forth, but with caveats regarding how quickly action would be taken should the numbers hit or exceed the targets. For instance, the Fed initially felt that once unemployment dropped below 6.5%, the economy might be on a sound footing and interest rates should be increased. But right from the start, Chairman Bernanke made clear that other data would have to be analyzed to ensure the health of the economy.