Defribulating the Economy

SUBHEAD: The US Federal Reserve will decide our economic fate beginning tomorrow. Let us pray. Image above: Jumpstarting the dollar. By Juan Wilson By Neil Irwin on 1 November 2010 for Washington Post - ( The Federal Reserve is preparing to put its credibility on the line as it rarely has before by taking dramatic new action this week to try jolting the economy out of its slumber. If the efforts succeed, they could finally help bring down the stubbornly high jobless rate. But should the Fed overshoot in its plan to pump hundreds of billions of dollars into the economy, it could produce the same kind of bubbles in the housing and stock markets that caused the slowdown. Or the efforts could fall short and fail to energize the economy, leaving a clear impression that the mighty Fed is out of bullets - thus adding even more anxiety to an already dire situation. The meeting of Fed policymakers Tuesday and Wednesday is set to be a defining moment of Ben S. Bernanke''s second term as chairman of the central bank. Although he helped win the war against the great financial panic of 2008 and 2009, he now risks losing the peace if he fails to end the protracted economic downturn that followed. Just two years after the world financial system nearly collapsed, it is again gut-check time for Bernanke. "The greatest risk for the Fed in taking this action is that it could extend the economy's funk by giving a sense that either no one is in charge or that the people who are in charge can't get it right," said David Shulman, senior economist at the UCLA Anderson Forecast. "The whole psychology of that could leak back into the economy." Jobs and prices The Fed is charged by Congress with a twin mandate of maintaining maximum employment and stable prices, and it is failing on both counts. The economy isn't in free fall. But as new data on gross domestic product affirmed Friday, the economy is mired in mediocre growth, too slow to bring down the unemployment rate. Inflation, meanwhile, is running about 1 percent, below the rate Fed officials view as optimal. When inflation is a little higher, it encourages consumers and businesses to spend money before it loses value. "Viewed through the lens of the Federal Reserve's dual mandate," William C. Dudley, the New York Fed president, said in a speech early last month, ". . . the current situation is wholly unsatisfactory." When Bernanke was confirmed earlier this year for a second four-year term, the widespread assumption was that his major task would be to decide when and how to move away from the unconventional measures taken during the crisis to boost growth. In reducing its target for short-term interest rates to zero, the Fed had exhausted its normal tool for managing the economy. So the central bank pumped money into the economy by buying vast quantities of bonds - more than $1.7 trillion worth. Now the Bernanke Fed is poised, if not to double down on that earlier bet, at least to up its wager. "Phase one was to avoid a complete market meltdown and something akin to the Great Depression," said Mark Gertler, a New York University economist who has collaborated with Bernanke on academic research. "Phase two begins now and is in some ways trickier. . . . Once again we're in a situation where we have to use policies we haven't really experimented with." The Fed is seeking to avoid the fate of Japan, where falling prices and weak economic growth over the past two decades have created a self-reinforcing economic stagnation. The hope is that by moving aggressively, such a cycle can be averted. Fed watchers expect that the two days of meetings around a giant mahogany table will culminate this week in the announcement of around $500 billion in Treasury bond purchases and perhaps a statement indicating a willingness to make even more. The intended benefits are already being felt. In anticipation of the Fed's action, investors have driven down mortgage rates, creating an extra incentive for people to buy a home. Expectations have also driven the stock market up, making Americans feel wealthier. And the dollar has fallen in value, making U.S. exporters more competitive, as currency investors reacted to an expected decline in U.S. interest rates. But there's a danger that the bond purchases could work too well. For example, while a modest decline in the dollar could be good for the economy, a steep and disorderly drop could be disastrous. And while Fed leaders want the inflation rate to be higher than it is now, if prices were to accelerate rapidly, that would be unwelcome. There's also a risk that investors could view the Fed's program of buying Treasury bonds as a signal that the central bank essentially plans to fund U.S. budget deficits indefinitely by printing money. That could prompt interest rates to rise, stymieing the economic recovery. Thomas M. Hoenig, president of the Kansas City Fed, appears likely to dissent from the Fed's decision this week. He said in October that such measures "could be a very dangerous gamble," given the risk of stoking asset bubbles, for instance in the stock market. If, on the other hand, the efforts to jump-start growth fall flat, the Fed would be confronted with an even knottier quandary: take even bolder steps, such as a trillion-dollar round of bond purchases, or admit that these kinds of measures won't work and stand pat. Encouraging spending Ultimately, the question of whether the Fed can invigorate the economy depends on whether companies, individuals and even the government respond to lower interest rates by spending and investing. Rates have been at exceptionally low levels for more than a year and corporate America is in sound shape financially, yet companies are holding back on hiring more employees and making new investments. Executives say they lack confidence that consumers will boost demand for products, because Americans are busy paying down debts. Some economists argue that the volume of bond purchases needed to jar the economy into motion again is vastly larger than what the Fed has seriously considered. Larry Meyer, a former Fed governor now with Macroeconomic Advisers, estimated last week that it would take more than $5 trillion worth, 10 times what analysts are expecting. Fed leaders deem such gargantuan numbers too risky. Either way, if the Fed overshoots or falls short, it could undermine the faith of the public and the financial markets in the ability of the government to address prolonged high unemployment and the risk of falling prices. At a time when investors are already skittish about gridlock in Washington, such doubts could spook financial markets, creating a self-reinforcing downward cycle in the economy. (By contrast, the U.S. economy flourished from the mid-1980s until 2008 in part because investors and businesses were confident that the Fed would keep the nation on a steady growth path.) A failed effort by the Fed could also prompt renewed calls to limit its authority and independence at a moment when popular discontent over its role in bailing out the financial system has already made the central bank a target for many in Congress. But some partisans of the Fed are urging it take dramatic new steps even if there's a chance they don't work. "I think the public understands that if unemployment remains high, monetary policy isn't going to be the reason," said Victor Li, a Villanova professor and former Fed economist. "No one is going to say the Fed isn't doing everything it can. .

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