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COLUMN-Whacking the economy with a wrench: James Saft
May 22, 2014 / 8:37 PM / 4 years ago

COLUMN-Whacking the economy with a wrench: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

May 22 (Reuters) - Did you ever get to the point when trying unsuccessfully to fix something you just start whacking it with a wrench?

I am getting the feeling that the Federal Reserve is approaching that point with the economy.

Fed officials have recently outlined some unconventional policy options that may indicate desperation, bravado or even, perhaps, a backward kind of genius.

Two main points stand out: that the Fed might want to tolerate inflation above its 2 percent target for a period, and that it may wish to have an almost permanent portfolio of bonds on its balance sheet

Taken together, these ideas underline the fragility and weakness of the recovery and indicate that a return to normal may be more of a hope than a hard target.

In some ways this is all understandable. Here we are, the better part of a decade into the financial follies and despite ultra low rates and wave upon wave of special measures, inflation is too low and employment far too weak.

Not only is this puzzling - or at least puzzling based on much of what Fed officials believed before the crisis - we are now reaching the point in the cycle where it is reasonable to wonder what the central bank might do if we entered a new downturn.

The most important idea - that the Fed might signal its willingness to tolerate above-target inflation - has recently been enunciated in slightly different forms by both Bill Dudley, head of the New York Fed, and the far more dovish Federal Reserve Bank of Minneapolis President Narayana Kocherlakota.

Dudley, in a speech earlier this week, argued simply that the 2 percent figure was a target, not a ceiling, and that as we had spent considerable time below it we might be expected to go above it as well.

Kocherlakota, without explicitly endorsing the idea, said that such “price level targeting,” in essence a period of catch-up inflation above the 2 percent target, “has the potential to affect the near-term speed of the economy’s recovery.”

The idea is that if the Fed sends such a strong signal, businesses will react by investing and hiring in anticipation of inflation and demand to come.

This might be achieved by targeting 2.5 percent over a five-year period, he said. It well might, but as ever, the worry is that the Fed loses credibility as an inflation fighter (yes, I hear you saying “what inflation?”).

In some senses, that’s exactly how it would work. If the economy, mired in too much debt, is unable to create inflation, the Fed may have to do it by giving a convincing impression of having taken leave of its senses.

The same crazy logic worked for the Swiss National Bank, in another context, when it essentially pledged to be the buyer of last resort of the euro in order to hammer the Swiss franc lower.


The other idea, that the Fed may want to continue re-investing the maturing proceeds of bonds held on its balance sheet even after the taper is over and it is buying no new bonds, is also radical in its own way.

Dudley too mentioned this idea in his speech, arguing that it may be better to wait until after raising the policy rate before halting re-investments. The idea is to gain some room on interest rates sooner, allowing the Fed some flexibility. It also would simplify communications, he argued.

Boston Fed President Eric Rosengren made an allied but different argument in an interview with the Wall Street Journal, but noted instead that a balance sheet might be useful in maintaining financial stability. That almost implies a permanently large balance sheet, because after all, financial stability is a permanent issue.

I am not actually arguing against this, as any thoughtful person should admit they are simply not sure about how advisable and dangerous it might be to foment inflation by saying you will put up with what usually is considered too much of it.

Having said that, nothing else has worked yet.

Even beyond rescuing the unemployed from their very real plight, one side benefit of inflation would be to lower the very high and quite possibly crushing burden of debt.

An unfortunate side effect (some might argue, object) of the way in which the financial crisis was fought - rescuing the banks and keeping homeowners on the hook - was that not very much debt was destroyed, despite there being so much debt as to be unsustainable.

Those debts must be defaulted or inflated away, as they impede the growth needed for repayment.

The unspoken choice might be between default in a new crisis or inflation - hopefully controlled - before that can happen. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at and find more columns at (Editing by Dan Grebler)

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