Monday, October 11, 2010

Fed to the rescue in US economic recovery?

Business Times - 12 Oct 2010

Fed to the rescue in US economic recovery?

But if it does more QE, then the US could be accused of doing what it says China is doing


EVEN the most cheerful forecaster looking to a speedy American economic recovery from the Great Recession would have been drowning in pessimism over the weekend in Washington.

A US government report indicating that the high unemployment rate was holding steady as state and local governments were continuing to cut more jobs while the private sector was failing to create new ones suggested that the fiscal and monetary measures adopted by the federal government have not succeeded in accelerating the promised recovery.

And while finance ministers and central bankers from around the world gathered in Washington for the annual meetings of the International Monetary Fund (IMF) and the World Bank last Saturday pledged to work together in trying to resolve the global economic tensions over exchange rates and trade, there were no signs that such cooperation was going to take place before the coming meeting of the leaders of the Group of Twenty largest economies (G-20) in Seoul next month.

In both the domestic and international arenas, the obstacles have to do with politics. Democratic and Republican leaders, on the eve of critical midterm Congressional elections, have no incentive to reach agreement on new fiscal measures to revive the economy before the voters determine the make-up of the new Congress next month.

And it is the failure of leaders in Beijing and Washington to agree on finding ways to deal with the global financial imbalances - that would require a more flexible Chinese exchange rate and a reduction in the US federal deficits - that is making it difficult to create an environment in which global economic tensions can be defused.

IMF managing director Dominique Strauss-Kahn referred to the inability on the part of the economic leaders meeting in Washington to agree on concrete steps to end the mounting 'currency wars', when he spoke with reporters after the IMF had issued a communique which committed its members to 'work towards a more balanced pattern of global growth, recognising the responsibilities of surplus and deficit countries'.

'The language (of the communique) is ineffective, and the language won't change things,' Mr Strauss-Kahn admitted, 'Policy has to be adapted,' he stressed.

Obama administration officials and Democratic and Republican lawmakers insist that the Chinese currency is the key in addressing the global financial imbalances. More specifically, they argue that Chinese intervention in the markets to keep their currency artificially low was giving an unfair advantage to Chinese exporters while hurting American manufacturing and destroying American jobs.

And, indeed, the US unemployment rate remained high, as was made clear by the new jobs report issued by the US Bureau of Labor last Friday.

The report indicated that payroll employment fell by a larger-than-expected 95,000 in September, while private sector employment increased by a less-than-expected 64,000 jobs - with unemployment staying stuck at 9.6 per cent.

It came as a major disappointment to economic officials in Washington, who recognised that the real unemployment rate was actually higher if one took into consideration those who had stopped looking for a job or had opted to take part-time work instead of full-time employment.

Most surprising was the extent to which state and local governments have been forced to respond to growing budget deficits by firing teachers and other government workers - suggesting that the effects of the economic stimulus package pushed by the Obama administration and the Democrats in Congress are receding.

While Republicans accuse the Democrats of wasting taxpayer money on a programme that has failed to stimulate the economy, Democrats are arguing that the stimulus programme helped save many jobs that would have otherwise been lost and blame the Republicans' rejection of new federal spending for the firing of government employees.

But the bottom line is that weakness on the employment front - and especially the signs that the private sector is now adding fewer jobs than it did in the spring - is pointing to an overall economy that has started to grow (but very slowly) and which is creating disincentives for consumers to spend and for businesses to hire. And it is also raising concerns that this slowdown in the economic recovery could set the stage for another recession.

And since the Obama administration and Congress seem to lack the political power and will to take action to pre-empt such a potential threat, the expectation in Washington is that the Federal Reserve will have no choice but to try to help speed the recovery by moving again in the direction of another quantitative easing (QE) and start pumping more money into the economy.

The Fed has already carried out some QE when it injected the economy with more than a trillion dollars as part of an effort to get consumers to start buying and companies to start hiring. But that didn't happen.

Banks and companies took the cheap money, but there hasn't been a lot of lending and hiring. The question now is whether QE2 will prove to be more effective.

The Fed will probably start with its QE2 when its policymaking body convenes next month. The process will likely involve the Fed buying perhaps as much as US$1.5 trillion in Treasury bonds, which should push interest rates on mortgage loans and small business loans down even further. That in turn could encourage businesses to expand and to hire new workers and consumers to spend and buy more merchandise, accelerating the economic recovery. Maybe.

And then there is the risk that printing money could ignite inflation and end up diluting the value of the US dollar. Indeed, reports that the Fed was considering QE2 have been putting downward pressure on the US currency, which could lead critics to argue that the Americans seem to be engaged in exactly what they accuse the Chinese of doing: undervaluing their currency.

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