This week, the US Federal Reserve’s Open Market Committee — the group of men and women who set US monetary policy — will be holding its sixth meeting of the year. At the meeting’s end, the committee is widely expected to announce the “taper”; a slowing of the pace at which it buys long-term assets.
Memo to the Fed: Please do not do it. True, the arguments for a taper are neither crazy nor stupid, which makes them unusual for current US policy debate. Yet if one thinks about the balance of risks, this is a bad time to be doing anything that looks like a tightening of monetary policy.
OK, so what are we talking about here? In normal times, the Fed tries to guide the US economy by buying and selling short-term US debt, which effectively lets it control short-term interest rates. However, since 2008, short-term rates have been near zero, which means that they cannot go lower (since people would just hoard cash instead). Yet the economy has remained weak, so the Fed has tried to gain traction through unconventional measures, mainly by buying longer-term bonds, both US government debt and bonds issued by federally sponsored home-lending agencies.
Now the Fed is talking about slowing the pace of these purchases, bringing them to a halt by sometime next year. Why?
One answer is the belief that these purchases — especially purchases of government debt — are not very effective. There is a fair bit of evidence in support of that belief and for the view that the most effective thing the Fed can do is signal that it plans to keep short-term rates, which it really does control, low for a very long time.
Unfortunately, financial markets have clearly decided that the taper signals a general turn away from boosting the economy. Expectations of future short-term rates have risen sharply since taper talk began and so have crucial long-term rates, notably mortgage rates. In effect, by talking about tapering, the Fed has already tightened monetary policy quite a lot.
Yet is that such a bad thing? That is where the second argument comes in: the suggestions that there really is not that much slack in the US economy, that it is not that far from full employment. After all, the unemployment rate, which peaked at 10 percent in late 2009, is now down to 7.3 percent and there are economists who believe the US economy might begin to “overheat” — to show signs of accelerating inflation — at an unemployment rate as high as 6.5 percent. Is it time for the Fed to take its foot off the gas pedal?
I would say no, for a couple of reasons.
First, there is less to that decline in unemployment than meets the eye. Unemployment has not come down because a higher percentage of adults is employed, it has come down almost entirely because a declining percentage of adults is participating in the labor force, either by working or by actively seeking work. At least some of the Americans who dropped out of the labor force after 2007 will come back in as the economy improves, which means the country has more ground to make up than that unemployment number suggests.
How misleading is the unemployment number? This is a hard question to answer, on which reasonable people disagree. The question the Fed should be asking is: What is the balance of risks?
Suppose that, on one hand, the Fed were to hold off on tightening, then learn that the economy was closer to full employment than it thought. What would happen? Well, inflation would rise, although probably only modestly. Would that be such a bad thing? Right now inflation is running below the Fed’s target of 2 percent and many serious economists, including the chief economist of the IMF, have argued for a higher target, say 4 percent. So the cost of tightening too late does not appear to be very high.
Suppose, on the other hand, that the Fed were to tighten early, then learn that it had moved too soon. This could damage an already weak recovery, causing hundreds of billions if not trillions of dollars in economic damage, leaving hundreds of thousands if not millions of additional workers without jobs and inflicting long-term damage as more of the unemployed are perceived as unemployable.
The point is that while there is legitimate uncertainty about what the Fed should be doing, the costs of being too harsh vastly exceed the costs of being too lenient. To err is human, to err on the side of growth is wise.
I would add that one of the prevailing economic policy sins of our time has been allowing hypothetical risks, like the fiscal crisis that never came, to trump concerns over economic damage happening in the here and now. I would hate to see the Fed fall into that trap.
So my message is: Do not do it. Do not taper, do not tighten, until you can see the whites of inflation’s eyes. Give jobs a chance.