Central banks need credibility. The ability to credibly commit to a policy shapes expectations in financial markets, and transmits important signals to the real economy. More recently, Fed credibility allows it to use its "communications tools", providing forward guidance to manipulate expectations, presumably for the betterment of overall economic activity.
Viewed from that perspective, the Fed very clearly has to increase its large-scale asset purchases (quantitative easing) after the meeting concludes on Thursday. It has said repeatedly that it has policy options it would use if economic conditions merited it. As witnessed by the most recent four employment reports – none of which showed employment growth, income growth, labor force growth and unemployment declines – economic conditions are quite weak. Moreover, the US faces global headwinds from a reduced pace of growth and the specter of financial shocks emanating from Europe.
If the Fed fails to act, markets can only conclude that either the Fed doesn't understand economic conditions, which is not likely, or that its credibility has been reduced. The Fed won't risk that conclusion.
That doesn't mean that further intervention will be effective in stimulating growth. As Chairman Bernanke said in Jackson Hole:
"Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces."
The US needs fundamental tax and spending reforms – especially in health and retirement programs – for which monetary policy simply cannot substitute. Indeed, the case can be made that neither "Operation Twist" nor "Quantitative Easing II" (QE2) had a substantial impact on output or employment growth. Put differently, while the Fed's interventions during the crisis were instrumental in turning the economic tide, not much it has done since has had a big impact.
A fair response is that monetary policy may have small benefits, but it is still worth trying. Fair enough, if there are low or no costs to action. Unfortunately, there are significant costs. First, further expansion of the Fed balance sheet makes the exit strategy even more complicated – and that is already unknown territory for the Fed and markets alike.
Second, the larger the balance sheet policy, the more likely the US will face a noticeable uptick in core inflation. Historically, the Fed tends to move late in tightening during economic recoveries. This particular Fed is populated with significant and influential voices (notably Chairman Bernanke and Vice-Chair Yellen) whose focus on deflation risks will ensure a slower exit. The exact timing of the uptick is not obvious, but it is nearly baked into the cake already. Further QE raises the onset and size of inflation risks.
Third, action now reduces the flexibility for action later. The Fed remains a powerful buffer against financial market turbulence. Given the state of European banking and sovereign finance, it is sensible to be concerned about the potential for a large shock at any moment. It makes little sense to give up some of the option to insulate from these shocks.
Finally, and perhaps most importantly, another move risks politicizing the Fed, a very serious cost. The events surrounding the Fed's QE2 in 2010 are instructive. Consistent with their communication strategy, Chairman Bernanke began to lay the groundwork for action during his August address at the Fed conference in Jackson Hole, Wyoming. The messaging was repeated and deepened throughout the fall of 2010, which was also the key campaign period during a very tumultuous election that featured backlash against big government, big spending and large debt.
Viewed from the perspective of challengers seeking office, particularly the large number of conservative, Tea Party candidates, the Fed essentially spent the entire election season telling Americans that it stood ready to buy whatever treasury debt the Obama administration deficits would generate. The simplistic conclusion that the Fed was actively aiding the administration, and Democrat incumbents, generatedpolitical outrage and strong public criticism of the policy.
A strong, credible, independent Federal Reserve is an important element of US economic policy-making, and an imperative for its future. With its actions Thursday, the Fed may endanger its credibility, its independence or both.
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