The Fed Stands Pat

There is an unusual conformity about most of the commentary surrounding the immediate economic outlook: we are in for a slow and possibly long slog out of the hole we dug for ourselves. Today’s release of the Federal Reserve’s Open Market Committee meeting minutes confirms that their view sits plumb in the middle of the already narrow range of forecasts. They, too, see the next few quarters as slow and steady. Actually, slow and unsteady may be a better description.

This of course befudddles the financial media whose only goal in life seems to be to grasp any shred of positive news and spin it into an immediate surge. Some of them even get confused over whether a decrease is an increase: this morning’s ADP report on private payrolls was that they decreased by 84,000 last month. This is much less of a decline than we have become used to over the past year or so. So much so that some media outlets blared that we have turned the corner on jobs as evidenced in the increase to be found in the ADP data.

Confused? So was I. Then again I have long ago given up on the financial media’s ability to perform even the most cursory analysis.

But back to the Fed.

The issue is now not whether the economy will recover – it will – but at what pace and whether there are enough risks that it could stall again. The consensus appears to be that growth will be much slower than we normally see after a steep recession, and that both inflation and interest rates will remain low.

No one should go planning for boom times.

I applaud the Fed for embracing the research that shows, beyond any reasonable doubt, that recoveries following a financially driven recession are always much more difficult and slow developing. There is a huge difference between such a recession and a more normal recession – one driven by an inventory cycle for instance.

In a ‘normal’ recession the immediate cause of a slump could be a sudden overshoot in production which sparks an equally sudden cutback and hence a surge in unemployment. Once supply is brought back into line with demand producers re-hire and try to re-stock quickly in order to avoid losing sales. This results in a sharp uptick in the economy before things settle back down towards a long run sustainable pace. In other circumstances it is the Fed itself who initiates the slump by raising rates in order to head off the inflation produced by an economy growing above its sustainable rate. Such ‘too rapid’ growth creates overheating in prices because resources such as labor gets to be scarce and wages rise rapidly. This floods the economy with cash which then drives up prices even more – too much money chasing too few goods.

Either way the shock that knocks the economy off its sustainable path is relatively easily dealt with and the adjustment takes only a few months. After the imbalances are overcome growth resumes with an initial burst followed by a return to normal.

A recession caused by a financial shock – the real estate bubble and the implosion of the banks is a classic example – is a very different animal. This is because of the deflationary risk, the need to undo the excessive valuation of assets, and the complicated interactions that go on between the credit and other financial markets. Critical parts of the economy, most notably the banks, need to be steadied before growth can resume at anything like its long run pace. Currency fluctuations are another common feature of a financially driven recession, with the result that trade is affected. The attempt top protect the currency can then destabilize interest rates and set in motion another round of currency problems. In short a financially created recession is a bigger mess to sort out, and very often some of the regular policy tools are ruled off limits because of their impact on the credit or currency markets.

That’s where we are now.

These kinds of crises were well described by Hyman Minsky, a disciple of Keynes. They are not described well at all in mainstream economics which has no room for banks in its models. Yes you read that correctly. Textbook economics – you may see it referred to as ‘neoclassical’ or ‘Chicago school’ economics – assumes an economy in which money is treated as an illusion or ‘veil’ behind which the ‘real economy’ of goods production and consumption exists. So mainstream theory ‘lifts the veil’ and ignores money as having much impact other than as a potential distortion to prices transmitted through the money supply – if the central bank screws up the money supply it will create inflation. Because of this attitude towards money, and its role, mainstream theory pays no attention to banks, finance or things like debt. They simply don’t exist in the purist’s models. It was Keynes who blew the whistle on this nonsense and gave money a constructive role to play in an economy through his notion of the ‘propensity to save’ and so on. Minsky then refined Keyne’s ideas and produced a fully thought through theory of financial crises. Ironically, or perhaps presciently, Minsky called the crisis stage of his model ‘Ponzi banking’. But, because the neoclassical/Chicago school came to dominate the textbooks both Keynes and Minsky were forgotten until recently.

There is no question that a Keynes/Minsky inspired legislator would advocate deregulation of banking. Far from it. Sometimes capitalism needs to be saved from itself, which is what Keynes argued.

Meanwhile back to today’s policy issues: we cannot lower interest rates because we are effectively at zero. We cannot raise them to head off inflation because the banking sector is too fragile. We have pumped enormous amounts of cash into the economy but people, and especially banks, are simply hoarding it or paying off debt rather than spending it. Our currency is declining which is good because it makes our products cheaper for foreigners to buy. But it also makes foreign goods more expensive which could fuel inflation, which we would normally head off by raising interest rates … which we don’t want to do because the banks are so weak.

Well you get the picture.

The Fed obviously grasps all this and is saying it wants to stick to its current policies for a while longer. That implies withdrawing a little from its support of the real estate market, which is already in the plan for the next few quarters, but not undoing, significantly, any of the other major supports put in place last year to avert disaster. The recovery just doesn’t look strong enough for the Fed to kick away the training wheels just yet. Maybe not at all during 2010.

So the upshot is that the Fed is standing pat. At least for now.