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Fed Kick-the-Can Solutions Inadequate to a Problem of Insufficient Demand

The Dow has had another one of these volatile, crazy days, off the irrational exuberance of yesterday’s late rally. Apparently investors thought that the Federal Reserve’s kick the can statement represented some kind of economic stimulus. The setting of mid-2013 as a target for continuing the zero interest rate policy plays the role of stimulus in this scenario.

I get it at some level. Definite low interest rates for two years allow you to lock in investments or flow into stocks, knowing that saving does little in terms of yields. And I see that Joseph Gagnon thinks there was even better subtext in the Fed’s remarks:

To make a conditional policy commitment for 2 years is a stunning reversal and unprecedented for a central bank as far as I know. Moreover, it does not mean (and they need to communicate this clearly) that they expect a continuation of less than 2 percent growth for the next two years. What it really means is that even if they get all the growth they expect (well above 3 percent for 2012 and 2013) that will not cause them to tighten policy. I think they should aim for 4 to 5 percent for two years, but they are probably not that aggressive.

Moreover, they clearly left the door open for QE3. I think they did not want to be stampeded by the stock market into a hasty move.

Most important, Bernanke showed himself willing at last to defy the hawks. They will never have enough votes to stop Bernanke from doing what he wants. Everyone on the FOMC knows that now. Yellen, Dudley, Raskin, Tarullo, Evans, and probably Duke will all support the Chairman if and when he wants to do more.

But there’s a difference between leaving the door open and acting, and clearly they failed in the latter. Which I think the markets recognized today. Some analysts see a better-than-even chance of a QE3, which investors seem to want. But even if that goes, I don’t know that we should view yesterday’s announcement as positive. Here’s Joseph Stiglitz.

Of course, those worried about the shortage of policy instruments are partially correct. Bad monetary policy got us into this mess but it cannot get us out. Even if the inflation hawks at the Federal Reserve can be subdued, a third bout of quantitative easing will be even less effective than QE2. Even that probably did more to contribute to bubbles in emerging markets, while not leading to much additional lending or investment at home.

The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy’s plight. But, even if it succeeds in stopping, at least temporarily, the slide in equity prices, it will not provide the basis of recovery: it is not high interest rates that have been keeping the economy down. Corporations are awash with cash, but the banks have not been lending to the small and medium-sized enterprises that are, in any economy, the source of job creation. The Fed and Treasury have failed miserably in getting this lending restarted – this would do more to rekindle growth than extending low interest rates though 2015!

But the real answer, at least for countries such as the US that can borrow at low rates, is simple: use the money to make high-return investments. This will both promote growth and generate tax revenues, lowering debt to gross domestic product ratios in the medium term and increasing debt sustainability. Even given the same budget situation, restructuring spending and taxes towards growth – by lowering payroll taxes, increasing taxes on the rich, as well as lowering taxes for corporations that invest and raising them on those that do not – can improve debt sustainability.

House Democrats are apparently poised to demand this as part of the Catfood Commission II, but that will go approximately nowhere. Heck, as long as credit rating agencies are the only companies that get listened to in Washington, I’ll cite that even Moody’s supports infrastructure spending. But that doesn’t mean it will get a receptive hearing.

Investors have their own reasons – bubble inflation being one – to support a QE3 that looks like QE2. The Fed has other monetary tools – a higher inflation target, canceling reserve payments for banks – but they haven’t really been roused to use them. Ultimately, we have a problem of insufficient demand, and we seem completely incapable of employing the perfectly normal tools to combat that.

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David Dayen

David Dayen