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Fed Risks Its Credibility on a Bowlful of Mush: Caroline Baum

It’s all over but the voting.

After all the speeches and the posturing, after the trial balloons and the press leaks, the Federal Reserve probably will announce another round of quantitative easing at the conclusion of its two-day meeting Wednesday.

The Fed embarks on this program with the intention of lowering yields on long-term Treasuries, which in turn will bring down mortgage rates and corporate bond yields. Surely there must be two or three households holding back on a home purchase because the 30-year mortgage rate at 4.2 percent is too onerous.

If QE1, which entailed the purchase of $1.4 trillion of agency debt and mortgage-backed securities (in addition to $300 billion of Treasuries), was about credit easing, QE2 then is about prices. I have yet to hear any Fed official talk about Q, about increasing the quantity of money -- specifically bank reserves -- which is where quantitative easing gets both its name and its heft.

Either the Fed is operating under a misconception about how QE2 will reduce unemployment and raise inflation, or it has failed to communicate the transmission mechanism to the public. Neither is a plus.

About the best thing anyone can say about the well-advertised and anticipated QE2 is that it won’t do much good. The worst thing is that it will inflate asset prices, which we don’t call inflation.

‘Violently Wrong’

Because Fed chief Ben Bernanke has been unwilling to admit the role low interest rates played in puffing up the housing bubble, he sees little risk from further easing, according to Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut.

At the same time, the Fed’s output gap models, which measure the difference between actual and potential growth and were “violently wrong in 2003 and 2004,” reinforce the majority view that deflation is the real threat, Stanley says.

Then there’s the Fed’s stated tactic of raising inflation expectations to lower real interest rates, a flawed concept even though it has succeeded splendidly in the short term.

In the two months since Bernanke first hinted at QE2 in his Jackson Hole, Wyoming, speech, five-year inflation expectations, the Fed’s preferred measure extrapolated from the yield differential between nominal and inflation-indexed Treasuries, have risen from about 2 percent to 3 percent.

Tortured Logic

So taken is the Fed with the notion that higher inflation expectations are the route to salvation that it has commissioned research on the subject. Last month, three Fed Board economists published a paper claiming that with overnight rates near zero, an oil price shock would be a plus for growth.

The “burst of inflation” from an increase in oil prices stimulates interest-rate sensitive sectors of the economy, the authors claim. (Aren’t higher oil prices a relative price increase unless the Fed prevents other prices from falling?) “In fact, if the increase in oil prices is gradual, the persistent rise in inflation can cause a GDP expansion,” they write.

Where are the speculators when you need them?

Ten years ago I wrote a column titled, “Fed Chairman Ali Naimi Has a Nice Ring to It,” referring to Saudi Arabia’s oil minister. The piece debunked the idea that oil prices can do the central bank’s job.

Maybe I was wrong. If you believe the research, we should be rooting for one of those old-fashioned oil shocks, circa 1973 and 1979, to fix what ails the U.S. economy!

Flawed Analysis

Raising inflation expectations to lower real long-term rates has two flaws. First, it assumes nominal rates don’t move. (The nominal rate consists of a real rate plus a premium for expected inflation.) Nominal rates could easily rise in sync with inflation expectations, leaving real rates unchanged.

The second reason has to do with the Fed’s credibility: real, expected and long-term.

“Credibility against deflation is tied to credibility against inflation,” says Marvin Goodfriend, professor of economics at Carnegie Mellon University’s Tepper School of Business in Pittsburgh.

What Goodfriend means is, the Fed has “the independence and operational capacity” to fight inflation and deflation via its control over bank reserves. What it doesn’t have is the luxury of overshooting to fight deflation, producing more inflation in the short run, when expectations have been manipulated higher. (While I agree with blogger Mish Shedlock that inflation expectations are “elegant nonsense,” I’m using the Fed’s framework to critique its logic.)

‘Late in Coming’

Almost two years have elapsed since the central bank pushed the funds rate to near zero. In that time, policy makers have failed to explain the framework for fighting deflation, Goodfriend says. Without that framework, it has to take risks with policy.

“The action is premature; the framework is late in coming,” he says of QE2.

It would be better to stabilize inflation expectations in the 1 percent to 2 percent range, the Fed’s implicit target since 1996, and provide a coherent framework for understanding how its actions affect the economy and prices.

Under Bernanke, monetary policy has become enamored with the idea that “communication and expectations adjustment is where all the leverage is,” says Timothy Duy, director of the Oregon Economics Forum at the University of Oregon in Eugene.

If the Fed has failed to communicate its framework for fighting deflation, as Goodfriend says, and if expectations aren’t your cup of tea, no wonder you’re nervous. Bernanke is headed into uncharted waters with no compass, no radar, and no stars to guide him.

The good news is he’s got plenty of fuel. The bad news: His only rations are gruel.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

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