POLICY FATIGUE / THE ECONOMIST ( A MUST READ )

The Fed, the budget and the economy

Policy fatigue

Policymakers seem helpless in the face of bad economic news

Jun 9th 2011
WASHINGTON, DC
from the print edition

WHEN America’s economic recovery stalled last summer, Washington swung into action. The Federal Reserve announced it would buy $600 billion of government bonds with newly printed money, pushing down long-term interest rates. Then, at the end of the year, Barack Obama struck an agreement with the Republicans to cut payroll taxes and extend unemployment benefits.
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Economic history seems to be repeating itself, in part. A promising recovery is again sputtering as job growth, which averaged 220,000 from February through April, slumped to 54,000 in May. The unemployment rate rose to 9.1%, the second monthly increase in a row (see chart). The economy grew at just a 1.8% annual rate in the first quarter and probably only a little faster in the second. Though not a double dip that barely qualifies as a recovery.


The response from Washington, however, is quite different from last year. In a speech on June 7th Ben Bernanke, the chairman of the Fed, acknowledged growth had been “uneven and frustratingly slow.” But as the Fed’s second round of “quantitative easing” (QE) draws to an end this month, he gave no hint a third round was in the offing.


To be sure, Mr Bernanke thinks the economy will pick up of its own accord as it shakes off the temporary restraints of Japanese supply chain disruptions and higher petrol prices. But if the malaise continues, the Fed, uncharacteristically, seems to have little confidence it can help. “Monetary policy cannot be a panacea,” Mr Bernanke said.


This has less to do with the results of QE2, which were positive: interest rates initially fell, as did the dollar, and stocks rose. What bothers the Fed is the price it paid: political blowback from foreign governments, Republicans on Capitol Hill, and even from inside the Fed itself. Such attacks can generate an unwarranted fear of inflation that frustrates the goal of QE.


If monetary policy seems indifferent to the economy, then fiscal policy is downright truculent. December’s stimulus agreement lasts only for a year: that virtually guarantees budget tightening come next January, similar to the current clampdown in the states caused by the ending of aid from the previous round of stimulus. Even before then, Mr Obama may have agreed to additional spending cuts to win Republican co-operation on raising the statutory limit on the national debt, currently set at $14.3 trillion. On May 31st, the Republicans who control the House of Representatives put an unconditional increase in the ceiling to a vote simply so that they could reject it. Republican negotiators now say they want $2.5 trillion in cuts over the coming decade to raise the debt ceiling by a like amount.


There are no signs of an agreement. Joe Biden, the vice-president, has been negotiating with Republican and Democratic congressional representatives but meetings have been hard to schedule because the House and Senate are in session at different times. It appears that discussion may not get serious until late in July, as the August 2nd deadline approaches.


At that point the Treasury warns that it will have to stop paying something, though it won’t specify what: interest on the debt, or other payments such as to government suppliers or pensioners. The first would clearly be a default in the eyes of America’s creditors. On June 8th Fitch, a rating agency, said such a default would trigger a downgrade of America’s credit rating from AAA to junk. The previous week Moody’s Investors Service warned that if August 2nd approached with no progress, it could put America’s rating on review for possible downgrade.


Republicans have generally pooh-poohed the risks of default. A handful of them say they would actually prefer it to unchecked spending. Many also claim that the federal government could avoid default by prioritising the way it pays its bills: interest on the debt first, other things later.


Such talk frightens the administration. Mary Miller, who manages the national debt for the Treasury Department, says picking and choosing among which of the government’s bills to pay would be an “operational nightmare”. More important, she says it could send such a negative signal about America’s financial governance that it could make the markets inhospitable to American debt. In August the Treasury must not only raise well over $100 billion to finance the deficit, but refinance more than $500 billion in maturing debt.


The impasse over the debt ceiling has yet to affect the bond markets: yields on government debt have actually dropped as the economic outlook has turned gloomier. Moody’s, for one, says it “fully expected political wrangling”. But, it added, “the degree of entrenchment into conflicting positions has exceeded expectations.” In such a situation, as historians know, accidents can happen.