What will the Fed Do?

The Federal Reserve governors are meeting today and tomorrow. There’s quite a bit of fretting over whether they’ll decide to raise interest rates or not. The editors of The Wall Street Journal remark:

The Fed has been able to skirt the scrutiny it deserves for the slowest recovery since World War II by maintaining near-zero rates and some bond-buying. The path of least political resistance now is to stand pat. There may be dissenters on the FOMC, but this decision will belong to Chair Janet Yellen, who studied at the James Tobin school whose Keynesian disciples have been writing that the Fed should wait.

But if not now, when?

They continue by citing the work of St. Louis Fed vice president Stephen Williamson that suggests, to no one’s surprise other than perhaps the Fed governors, that quantitative easing has done nothing either to goose inflation or to encourage investment:

Mr. Williamson examines the history of monetary policy following financial crises and argues that “there is no work, to my knowledge, that establishes a link from QE [bond-buying] to the ultimate goals of the Fed—inflation and real economic activity. Indeed, casual evidence suggests that QE has been ineffective in increasing inflation.”

He’s right, which is the opposite of what some monetarists predicted (including on these pages) when the Fed accelerated its bond-buying in 2010 after the recession had ended. This has surprised the Fed too. As former Fed Chairman Ben Bernanke explained the theory, buying bonds with long maturities would reduce interest rates, which would lift asset prices and ultimately economic growth and inflation. It hasn’t worked out that way, and FOMC members have consistently underestimated growth and inflation since the recovery began.

Mr. Williamson points out that “the Fed has undershot its inflation target of 2% since early 2012,” and that is the norm for central banks across the world. “Indeed, mainstream monetary theory and the experience of Japan for the last 20 years tells us that extended periods of ZIRP [zero-interest-rate policy] lead to low inflation, or even deflation.”

He says this can leave bankers “trapped in ZIRP” because “inflation is low, and the central banker reasons that maintaining ZIRP will eventually increase the inflation rate. But this never happens and, as long as the central banker adheres to a sufficiently aggressive Taylor rule [a monetary price rule], ZIRP will continue forever, and the central bank will fall short of its inflation target indefinitely. This idea seems to fit nicely with the recent observed behavior of the world’s central banks.”

Meanwhile Kentucky Sen. Rand Paul and economist Mark Spitznagel make a somewhat stronger argument:

The “doves” are right to point out that higher interest rates will lead to a repricing of many securities, aka a crash. But years of near-zero interest rates have made this inevitable. Continuing on the current course will only allow structural distortions caused by these interest rates to fester and an inevitable reckoning that will be much worse than seven years ago.

The master fallacy underlying so much economic commentary is to imagine that a handful of experts in Washington should be setting the price of borrowing money. Instead, the Fed should set markets free.

but it’s not one that I think that very many people would find appealing. It’s the problem that all minarchists and anarch-capitalists face. It might well be true that markets would do a better job (if, indeed, there are markets or markets could be created to “set free”, far from a done deal). But that’s not the situation we have now and the period of adjustment would be truly miserable. Millions would lose their jobs. That’s millions of voters.

It also fails to take globalization into account. Basically, we’ve been exporting inflation for the last 9 years.

That’s why I think the best course available right now is for the Fed to keep interest rates where they are, to end quantitative easing and keep it ended, and for the Congress to get off their collective spreading derriere and start taking the steps to mitigate the risks posed by long-term very low interest rates.

They might think about making the structural changes we need to get the economy back on track but that’s pie in the sky stuff. There’s already enough fantasy in this post as it is.