At a presentation billed as a speech on whether or not recent college graduates are finding good jobs, New York Federal Reserve Bank President William C. Dudley signaled his desire for continued stimulus in a strong way. Only a small portion of the speech talked about college or job opportunities, while the majority focused on national economic conditions and Dudley’s preferred policy prescriptions.
Dudley places the blame for continued economic sluggishness directly on the so-called “sequester” cuts and less directly on the very large tax increases instituted earlier this year. He says the economy is in a “tug-of-war between fiscal drag and underlying fundamental improvement.”
Unfortunately, the improvements in consumer spending on durable goods and housing are not yet showing through in the overall GDP growth rate due to the significant headwinds that we continue to face. First, federal fiscal policy has recently become quite contractionary. Estimates from the Congressional Budget Office (CBO) indicate that this fiscal restraint is on the order of 1.75 percentage points of potential GDP this year. In the period since 1960, there have been only two previous episodes of fiscal contraction of this order of magnitude—1969 and 1987—both of which occurred when the economy was on a more solid footing than it is today. Second, the euro area is experiencing a protracted recession and growth in many of the largest emerging economies has slowed. This has resulted in a very sharp slowing of U.S. exports, with an associated slowing in production and employment growth in the U.S. manufacturing sector.
Dudley exposes the reality of the Fed’s folly that it can make predictions about the market. Yet it seems as though the FOMC is relying completely on its predictions. Any rational person will quickly realize however that those predictions are based on real time data that are still being revised.
In its statement, the FOMC said that it may vary the pace of purchases as economic conditions evolve. As Chairman Bernanke stated in his press conference following the FOMC meeting, if the economic data over the next year turn out to be broadly consistent with the outlooks that the FOMC sees as most likely, which are roughly similar to the outlook I have already laid out, the FOMC anticipates that it would be appropriate to begin to moderate the pace of purchases later this year. Under such a scenario, subsequent reductions might occur in measured steps through the first half of next year, and an end to purchases around mid-2014. Under this scenario, at the time that asset purchases came to an end, the unemployment rate likely would be near 7 percent and the economy’s momentum strengthening, supporting further robust job gains in the future.
Here, a few points deserve emphasis. First, the FOMC’s policy depends on the progress we make towards our objectives. This means that the policy—including the pace of asset purchases—depends on the outlook rather than the calendar. The scenario I outlined above is only that—one possible outcome. Economic circumstances could diverge significantly from the FOMC’s expectations. If labor market conditions and the economy’s growth momentum were to be less favorable than in the FOMC’s outlook—and this is what has happened in recent years—I would expect that the asset purchases would continue at a higher pace for longer.
Toward the end of his rundown of national economics, Dudley attempts to make it clear in the boldest terms he can that there is no way the Fed will allow the market to fall without tossing the kitchen sink at the problem.
Fourth, even under this scenario, a rise in short-term rates is very likely to be a long way off. Not only will it likely take considerable time to reach the FOMC’s 6.5 percent unemployment rate threshold, but also the FOMC could wait considerably longer before raising short-term rates. The fact that inflation is coming in well below the FOMC’s 2 percent objective is relevant here. Most FOMC participants currently do not expect short-term rates to begin to rise until 2015.
Dudley and his fellows on the FOMC are trying to catch a tiger by the tail. There is no way they can control the entire world’s economy effectively, though that seems to be what they are attempting. This can’t end well.
