Will US Fed change direction soon?

Business Times - 06 Jan 2011

Will US Fed change direction soon?

Pressure from the new Congress and the changing composition of the Fed could put paid to loose monetary policy


THE Republican electoral wins in last year's midterm congressional elections and the new appointments to the US Federal Reserve's policy-making body, the Federal Open Market Committee - coupled with signs of accelerated economic recovery - have ignited speculation that Fed chairman Ben Bernanke will be forced to reassess the central bank's loose monetary policy.

It is being said that he will bring to an end its earlier decision to purchase billions more in Treasury bonds - otherwise known as quantitative easing (QE).

In a way, in response to the financial crisis and the ensuing Great Recession, the Federal Reserve has been pursuing what some consider to be the most relaxed monetary policy in its history. In fact, the Fed is currently managing a balance sheet in excess of US$2.4 trillion.

A long period of near-zero short-term interest rates together with US$600 billion of additional quantitative easing, or QE2, should seem like a reasonable policy choice in response to a lower-than-desired inflation rate and a higher-than-desired unemployment rate (of close to 10 per cent).

Since the Fed's two main responsibilities are ensuring that the rate of both inflation and unemployment are 'just right', Mr Bernanke and his colleagues have hoped that QE2 would create more incentives for financial institutions to lend to business and consumers as part of a strategy to increase economic growth and contain the threat of deflation and unemployment.

But 2011 has begun with rising hopes for stronger growth and job creation (good news for the Fed), and rising inflation expectations (bad news for the Fed). This mix of good and bad news could create pressure on the Fed to start pursuing an 'exit policy', including the tightening of monetary policy and reducing its bloated reserve balances.

Adding to this pressure to reverse policy are the new political and institutional realities.

The Republican victories in the mid-term elections were propelled in part by populist sentiments that are driving the Tea Party movement, with members critical of the US central bank that they consider a political tool of the 'elites' on Wall Street and in Washington.

Reflecting the growing power of the Tea Partiers will be the election of a long-time critic of the Fed, Texas Republican Representative Ron Paul, to take over the House of Representatives' committee that is responsible for overseeing the Fed.

In fact, Mr Paul - who will probably try to win the Republican Party presidential nomination in 2012 - has written a best-seller that calls for getting rid of the Fed. He is expected to launch a massive public assault against the central bank, by questioning its policies and demanding that the Fed's policy-making become more transparent.

Moreover, Mr Paul and many populist Republicans are expected to challenge the easy money policies pursued by the Fed that they denounce as 'printing money', and warn that it could lead to runaway inflation while debasing the value of the US dollar.

In that context, Mr Paul and other Republican lawmakers and conservative pundits have attacked the QE2 programme of asset-buying and seem to be trying to use Mr Bernanke as a political punching bag, portraying him as an ideological supporter of President Barack Obama.

They are suggesting that the Fed is following, on the monetary front, the same kind of irresponsible fiscal approach pursued by the White House that is bound to expand the deficit and trigger inflation.

Indeed, raising concerns about the threat of inflation, former Alaska governor and likely Republican presidential candidate Sarah Palin called on Mr Bernanke to 'cease and desist' with the QE2 programme.

At the same time, some Republican lawmakers have proposed changing the Fed's mandate so that it would focus exclusively on controlling prices, and no longer on expanding employment.

Then, there is the changing make-up of the Fed's voting bloc, with the balance of the power on the policy-making group shifting in the direction of inflation hawks who, like many Republicans and conservatives, want to see the Fed doing less to fight unemployment and to focus most of its attention on preventing inflation.

Indeed, one of the new Fed voting members, Charles Plosser, the head of the Philadelphia Federal Reserve, has expressed his concerns over QE2. 'I am still somewhat sceptical that we will see much of a stimulative effect from this new round of purchases,' Mr Plosser said in a recent speech.

Inflation hawks such as Mr Plosser will probably point out that the economy is growing with consumer spending recovering, manufacturing expanding and jobless claims at more than a two-year low. What will play into the hands of those calling for ending the QE2 programme is the expected effect of last month's agreement between the White House and Congress to cut taxes and increase spending - a move that could add as much as a full percentage point to economic growth this year.

And while rising oil and other commodity prices raise the spectre of inflation, they could also hurt consumer purchasing power and slow economic growth.

There is a complex set of indicators - signs of moderate economic growth together with a very high rate of unemployment, the overall feeling that consumers and businesses have yet to demonstrate their confidence by spending and investing, and that inflation is not likely to be a problem in the foreseeable future. And these signs suggest that the Fed would probably resist political pressure from outside and refrain from raising the federal funds rate, while continuing with its current QE2 programme.

And what about a possible QE3? When the Federal Reserve in early November announced its plan to buy US$600 billion worth of Treasury bonds, Mr Bernanke went out of his way to leave the door open to additional purchases in the future.

'The committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase programme in light of incoming information and will adjust the programme as needed,' the Fed said in the statement at the time.

Now, even if Mr Bernanke and some of the Fed's inflation doves conclude that another round of asset purchases is required, the pressure from the new Congress and the changing composition of the Fed could make a move in that direction very unlikely.

Copyright © 2010 Singapore Press Holdings Ltd. All rights reserved.


Fox said…
Yesterday's FOMC meeting signaled no sign of change and with the Fed's current measures of inflation, etc. it doesn't seem likely. Thomas Hoenig moving off the committee hurts the chances of curtailing such programs as well.

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