By Victor Li |
Since the end of the recession in 2009, U.S. growth has been weak and the unemployment rate has fallen largely because fewer people are participating in the workforce. The Federal Reserve has had its foot on the gas pedal as hard as it can, setting the short rate of interest close to zero, supplementing this with bond purchases in huge volumes (quantitative easing or QE), together with forward guidance about rates staying near zero. Easy money policies have worked in the past by stimulating the construction sector, increasing home prices and encouraging exports.
They have done the same this time, but have been much less effective because housing and commercial construction were overbuilt and then blasted by the financial crisis and exports have struggled in a weak global economy. Moreover, federal tax increases and spending cuts have been holding back growth this year, and state and local governments have been cutting back for several years.
There have been dire warnings about the likely impact of the Fed's policy on inflation, on the grounds that expectations of inflation would jump, triggering a self-fulfilling prophecy of price increases. These fears have not been realized, with measures of inflation expectations remaining very subdued and actual inflation trending downwards.
Janet Yellen is taking over as Federal Reserve Chair and she faces a divided FOMC (the Fed's decision-making committee) with several members wanting to end the easy money strategy, but others demanding it continue until a stronger recovery is in evidence. Which side of the debate is correct?
President Truman famously asked for a one-armed economist because his advisors kept saying "on the one hand this, and on the other hand that," but the truth is there are pluses and minuses for most economic policies. On the one hand, expansionary monetary policy has not been successful in stimulating a strong recovery, and there are concerns about keeping interest rates so low for so long. This distorts asset pricing and encourages markets to "reach for yield" by looking for higher returns through clever but risky financial strategies.
On the other hand, low interest rates have contributed to a partial recovery in residential construction and home prices, and they have boosted auto sales. They have helped growth be stronger than it would have been otherwise. Inflation is low — below the Fed's 2 percent target -- and unemployment has been above 6 percent for 65 months. It is unfortunate that monetary policy is the only game in town pushing the recovery forward, but since it is, a major Fed pull back would be a mistake.
A Janet Yellen-led Federal Reserve is likely to start scaling back its bond buying when the FOMC meets in March of 2014, but to maintain a zero interest rate policy until 2015 as long as the economy remains weak. This is the right answer and I support it.
About Martin Neil Baily Senior Fellow at the Brookings Institution
Warren Mosler Co-Founder of the Center for Full Employment And Price Stability
Mark Weisbrot Co-Director of the Center for Economic and Policy Research,
Mark Calabria Director of Financial Regulation Studies at the Cato Institute
Jeffrey Madrick Senior Fellow at the Roosevelt Institute