The Fed Strikes (out) Again!

The August 10, 2011 news headlines boldly announced – the Federal Reserve Bank (Fed) guaranteed super-low interest rates for two more years. What beliefs underlie such an historic declaration and what are the likely consequences?

First, the Fed must think current economic conditions portend a dismal economy for an extended period. Second, they must believe they have the ability to correct, or at least mitigate, those problems without serious side effects. How much confidence should we have in the central bank’s ability to diagnose the problem and come up with an effective solution? Not much based on recent history! The Fed believed their recent quantitative easing (QE2) program, which kept interest rates artificially low, would buoy the stock market, reduce unemployment and spur the economy. However, according to a study by The American Institute for Economic Research, “The projected annual impact of lost interest income translates into $256 billion of lost consumption, a 1.75 percent loss of GDP, and about 2.4 million fewer jobs. Had these jobs not been lost, the unemployment rate would be 7.5 percent, instead of the current 9.1 percent, and this is the minimal effect we estimate.” Benefits, if any, were short-lived and the costs included severe distortions in commodity prices and higher inflation. Retirees, dependent on investment income, cut their spending which discouraged businesses from hiring. Underfunded pension funds had a harder time meeting their already exaggerated investment return assumptions. The result:  state and local government layoffs to compensate for higher pension contributions. In other words, the Fed’s belief that it can manipulate interest rates without causing significant harm  is, at best, questionable and, at worst, totally wrong.

The newly announced interest rate stabilization policy is likely to cause similar problems. Of course, everyone’s entitled to a mistake. Let’s check – have there been other recent blunders by the Fed? More than a few, but two under Chairman Bernanke stand out. Bernanke testified to Congress in 2007 that the subprime mortgage crisis was “likely to be contained.” Later he admitted he had failed to recognize financial system flaws that led to the economic crisis. He has also admitted that on his watch the Fed failed to maintain appropriate regulation and adequate supervision over the country’s financial institutions. No one expects perfection. The last several years have been turbulent and unpredictable; appreciation of the challenges faced is surely warranted. Nonetheless, given the magnitude and frequency of the past misjudgments, a prudent mantra for the Fed might be “don’t just do something, stand there.”

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