Federal Reserve Chairman Ben Bernanke believes government functions best in sunshine, when decision-making is transparent and predictable. I usually applaud this philosophy.
But I’m perplexed – or perhaps dazzled is a better word – by the Fed’s announcement yesterday that it intends to hold interest rates at ultra-low levels until at least late 2014. The idea is to encourage consumers and businesses to spend money, confident that the government will not let interest rates rise until a sustainable economic recovery is well underway.
Last summer, the Fed promised to keep rates at rock bottom until the middle of 2013. That was roughly a 24-month window, which is a long time to plan monetary policy in advance. Now, barely into 2012, the promise has been extended to something between 30 and 36 months. That’s about 21 dog years, and close to eternity in Central Bank timekeeping.
The goal of these extended promises is to reduce uncertainty. But there can be too much certainty in government, just as there can be too much sunshine when you drive westbound on a highway in late afternoon. The glare can be blinding.
Maintaining today’s interest rates only makes sense, if at all, on the assumption that economic conditions will warrant mega-cheap money for the next two to three years. The Fed clearly expects this to be the case. Slow hiring in the United States, continued high unemployment, modest inflation and, especially, continued financial turmoil in Europe (accompanied by government austerity and economic contraction) make the case for the current policy. This scenario could, indeed, play out – but so could a lot of others.
The U.S. economy might rebound more sharply and quickly than the Federal Reserve presently expects. Or Europe might get its financial house in order sooner, bringing down government borrowing costs while hidebound private industry starts to flex its muscles. Or continuing American budget deficits could prompt investors to shun Treasury debt in favor of gold and other commodities, forcing inflation higher despite slow growth.
Before last summer, we had a pretty good idea how the Federal Reserve would react in those situations. A generation of vigilance against inflation gave us reasonable confidence that if prices began to seriously spike, the Fed would tighten credit, even if doing so drove unemployment higher in the short term. Loosening again would be possible once inflationary pressures abated.
The promise that the Fed made last summer and extended yesterday introduces a new variable. Conditions may change. The Fed has reserved the right to react to changed circumstances by altering its monetary policy – but doing so could be perceived as going back on its promise, damaging the central bank’s credibility for years to come. So the Fed is likely to be reluctant to tighten its policy earlier than it said it would, even if future developments make tightening desirable.
The question is how much pressure it would take to induce the Fed to change its stance. Nobody, not even the current members of the Fed’s rate-setting Federal Open Market Committee, can know for certain. The rest of us must choose between two assumptions. The first is that, despite its comforting words about keeping rates where they are for an extremely long time, the Fed will ultimately do whatever it thinks it must. Anyone who believes this will consider the low-rate pledge an empty promise, and if enough people believe this to be the case, the pledge will fail to encourage any change in financial behavior.
The second option is that the Fed will hold on to its low rates as long as it possibly can, consistent with its pledge, but perhaps inconsistent with actual economic developments. If you believe this, then you have to believe the Fed has monetary policy on autopilot. The result could well be an inflationary surge and a dollar crash. Once it finally did act, the Fed would probably overcompensate by excessively tightening policy to re-establish its inflation-fighting credentials. We might end up with a short-term recovery at the cost of a harsh recession afterwards.
An economy the size of ours does not change direction readily, but when it does move, it can do so with surprising speed. Imagine if the Fed had tried to set monetary policy three years ahead in mid-2006. We were proceeding merrily through a debt- and real estate-fueled expansion, and almost nobody foresaw the crash that came in 2008 and the following recession that extended well into 2009. The Fed’s policy at the time, which was to react as circumstances dictated, gave it the flexibility to move creatively and forcefully to stem the damage and protect the global banking system. There is a risk that its current longer-term pledges will gum up our monetary machinery, leaving it permanently behind the curve.
I understand why the central bank wants to offer as much reassurance as it can. There is nothing reassuring, however, about pretending to know more about the future than we actually know. Economic decision-making in the political branches of our government is already chronically slow, which makes it more important than ever to have a responsive and responsible central bank. I know Bernanke and his colleagues are trying to help, but please, folks – pull down the visors. We can’t see where we’re going.
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