The Fed Got It Right Yesterday

(But Let's Drop the Fiscal Package)

For the second time in just over a week, I have proposed bold action for the FOMC, not really expecting them to take my advice.  And for the second time in just over a week, they were even bolder than I recommended.  That gave us what I thought we needed, but more than I dared ask for. What's going on here?

My first recommendation for a 50 basis points reduction in the target Fed Funds rate got us 75.  Then, I hoped for another 50, predicted only 25, and we got the 50. I have been conditioned to expect excessive caution.  I guess I need to be reconditioned, or, like the sexy woman in my GPS says when I don't take her advice, "I'm recalculating."

My probability for a recession keeps going from just under 50 percent to just over 50 percent.  I had been encouraged by four consecutive declines in new claims for unemployment insurance, down to 301,000. Then yesterdays new orders for durable goods came in strong. But yesterday's advance estimate for fourth quarter GDP was a disappointing 0.6 percent, although that included significant inventory run down, which will be reversed.

Then jobless claims reported this morning jumped up by 69,000 and last week was revised down slightly. I guess the slowdown has finally softened the labor market.  Still, I don't expect unemployment to go much over 5 percent in January, and a slight reduction wouldn't surprise me.

The large reductions in the target Fed Funds rate finally gave some needed upward slope to the yield curve which is very helpful to banks and other financial intermediaries that borrow short and lend long.  Rate reductions in 1993 gave the yield curve a steep positive slope and finally ended the credit crunch that threatened to linger forever. 

So, what about the fiscal package that just passed the House and is likely to go from bad to worse in the senate? Will it help prevent recession, or hurt?

There may be a very narrow sense in which it will help marginally by adding modestly to total spending. But, when you look at it more broadly and consider longer run consequences, the modest help comes at a high price in terms of increasing the budget deficit, implying higher tax rates down the road. 

The rebates will be borrowed from one group of citizens and given to another group, with no incentive value at all.  The net impact of that, we learned in Money and Banking class, depends primarily on what's happening with monetary policy at the same time.  If monetary policy doesn't ease sufficiently, the borrowing will be from existing money and more spending by the recipients will be offset, or partially offset by reduced spending by others.  You get a bit more expansion, but very little, if you finance with newly created money, but no newly created bank reserves.  To get the maximum bang for the buck, the extra spending should be accompanied by an expansion of both money and bank reserves-a very easy monetary policy.

But, as I said in the previous posting (The San Diego Op Ed), if monetary policy is ideal, the fiscal policy will be redundant.  Why not just go with monetary policy and keep the deficit lower?

Timing is another issue.  We just had a dramatic example of how fast monetary policymakers can act once the make up their mind to.  Fiscal policy takes much longer to put in place and may just add to inflation when it kicks in after recovery has started.

Some of the business portion of the fiscal package contain some incentive to invest and may do some good.  However the good is not so good as to offset the bad of rebates.  Those business incentives should be considered separately and should become a permanent feature of the tax code than a temporary feature.  If we aren't careful we may hurt investment by promising incentives sometime in the near future.

We may or may not avoid a recession, but either way the economy is likely to be sluggish for a while.  Not as sluggish, however, as it would have been without the aggressive monetary action.  We need to monitor monetary policy carefully however, because of the exclusive focus on interest rates.  The fundamental impact of monetary policy, especially on inflation, and on the monetary assistance given to fiscal ease, depend on the growth of the money supply.  Narrow measures of money have been pretty flat lately. Broader measures of money have been growing, but not very fast.

Mr. Bernanke, don't take your eye off money.  Here, as elsewhere, it pays to follow the money.