Federal Reserve Governor Daniel Tarullo’s recent testimony on the European debt crisis illustrates a significant inconsistency with between the Fed’s outlook and its policy. Honestly, if Tarullo actually believes with he says, the Fed needs to be pursuing a much more aggressive policy. But the FOMC is actually debating the opposite – when and how to reverse its swelling balance sheet.
Tarullo highlights the two obvious negative channels by which the European crisis will feed into the US economy. The first is financial:
These effects on U.S. markets underscore the high degree of integration of the U.S. and European economies and highlight the risks to the United States of renewed financial stresses in Europe. One avenue through which financial turmoil in Europe might affect the U.S. economy is by weakening the asset quality and capital positions of U.S. financial institutions…
…In addition to imposing direct losses on U.S. institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally. Increases in uncertainty and risk aversion could lead to higher funding costs and liquidity shortages for some institutions, and forced asset sales and reductions in collateral values that could, in turn, engender further market turmoil. In these conditions, U.S. banks and other institutions might be forced to pull back on their lending, as they did during the period of severe financial market dysfunction that followed the bankruptcy of Lehman Brothers.
The second is via trade linkages:
Another means by which an intensification of financial turmoil in Europe could affect U.S. growth is by reducing trade. Collectively, Europe represents one of our most important trading partners and accounts for about one-quarter of U.S. merchandise exports. Accordingly, a moderate economic slowdown across Europe would cause U.S. export growth to fall, weighing on U.S. economic performance by a discernible, but modest extent. However, a deeper contraction in Europe associated with sharp financial dislocations would have the potential to stall the recovery of the entire global economy, and this scenario would have far more serious consequences for U.S. trade and economic growth. A resultant slowdown in the United States and abroad would likely also feed back into the health of U.S. financial institutions.
Tarullo acknowledges that the European crisis is largely a European problem, while the Fed is reduced to a limited supporting role. What caught my attention was first this section regarding the potential for financial disruption:
The timing of such an event in the current instance would be unfortunate, as banks generally have only recently ceased tightening lending standards, and have yet to unwind from the considerable tightening that has occurred over the past two years. Moreover, aggregate bank lending, particularly to businesses, continues to contract. The result would be another source of risk to the U.S. recovery in an environment of still-fragile balance sheets and considerable slack. Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests that it is not out of the question.
The fact that aggregate bank lending continues to contract, that the Fed is obviously aware of this, and that, according to Tarullo, the European crisis has the potential to aggravate an already existing problem all clearly point toward a more aggressive quantitative easing program than in place. Actually, what is happening is the Fed is considering a quantitative tightening program:
Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions. The strategy should be consistent with the achievement of the Committee’s objectives of maximum employment and price stability. In addition, the strategy should normalize the size and composition of the balance sheet over time. Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy. Returning the portfolio to its historical composition of essentially all Treasury securities would minimize the extent to which the Federal Reserve portfolio might be affecting the allocation of credit among private borrowers and sectors of the economy.
Tarullo also presses for a hawkish fiscal stance:
The United States is in a very different position from that of the European countries whose debt instruments have been under such pressure. But their experience is another reminder, if one were needed, that every country with sustained budget deficits and rising debt–including the United States–needs to act in a timely manner to put in place a credible program for sustainable fiscal policies.
Interestingly, Tarullo seems to suggest that the US response to fiscal problem in Europe should be to tighten US fiscal policy on roughly the same timetable the Fed is looking forward to tightening US monetary policy.
To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with. But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy. At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly, and inflation continues to trend downward.
All of which together suggests that the Fed’s policy stance is seriously out of whack with policymaker’s interpretation of actual and potential economic developments. And I have trouble explaining the disconnect.