The Fed is out of ideas

Today’s Wall Street Journal has an article by Jon Hilsenrath about what the Fed is likely to consider in its upcoming meeting on November 1 and 2 in response to the stubborn weakness of the U.S. economy. This is significant because Hilsenrath is the journalist that the Fed trusts the most for conveying its views to the public. A close reading of what he wrote can tell us a great deal about what the members of the FOMC are thinking. Worryingly, it appears that they are out of good ideas.

Growth is sluggish because household liabilities are too large relative to personal income. This problem had been masked during the boom because the typical American’s assets had grown at a sufficiently brisk pace to keep up with the growth in liabilities:

Now that those assets have lost $7 trillion in value, the insufficiency of income has started to hurt. The only solution is to increase incomes through wage inflation and decrease debts through defaults.

According to Hilsenrath, the Fed seems at least partially aware that the burst bubble is the source of the problem. He describes a speech delivered yesterday by Governor Daniel Tarullo that focused on the role of the housing market:

In his speech Thursday, Mr. Tarullo argued that there was a need and “ample room” for additional measures by the Fed…and he said housing was where the Fed should direct its attention.

“Housing continues to hang like an albatross around the necks of homeowners and the economy as a whole, with millions of underwater mortgages, a staggering inventory of foreclosed homes, and depressed levels of sales,” he said.

Yet, according to Hilsenrath, the Fed would prefer to reflate asset prices to the unsustainable levels of the past:

Federal Reserve officials are starting to build a case for a new program of buying mortgage-backed securities…to push down mortgage rates.

Lower mortgage rates, in turn, could encourage more home buying and mortgage-refinancing, and help the economy by freeing up cash for consumers to spend on other goods and services. Mortgage rates are already very low, but some Fed officials believe they might be pushed lower. Moreover, Fed officials believe their past purchase programs helped to lift stock markets, by driving investors from low-risk investments toward riskier investments.

Their proposed solution would do nothing to address the underlying problems. Hilsenrath’s account makes it clear:

Nearly 28 million outstanding mortgages have interest rates above 5.1% and are in theory ripe for refinancing, according to CoreLogic, a household-finance research firm. Many of them haven’t been refinanced because of high fees and because homeowners have too little equity in their homes to qualify.

It is possible that lower rates would help only borrowers who already have good credit, and not underwater homeowners.

Hilsenrath was being charitable. The mortgage rate could fall to 0% and it would barely make a whit of difference. The people who actually need the help will never get refinancing because they have negative equity, bad credit, and no job. Even if they were able to refinance, they would be unable to pay their bills because the principal would still be too big to support with their incomes.

It is true that the people who are already able to pay their bills will have slightly more cash in their pockets if they refinance and that they could spend this money to boost the economy. Of course, they could also squirrel it away to rebuild their savings or spend it on imports, neither of which would do much good for the rest of America.

The same analysis applies if the Fed manages to juice the stock market, although so far the success of its interventions has proven short-lived:

Not only would this additional round of bond-buying likely fail to achieve its express purpose of fixing the housing overhang—it would also have unfortunate distributional consequences. The nation’s financial assets, including the stock market, are overwhelmingly owned by the richest 10% of Americans. Boosting the prices of stocks and bonds without addressing the fundamental problems plaguing the economy would give free handouts to people who need it the least without doing anything for anyone else. If Fed policymakers really want to go down this road they should openly lobby Congress for tax cuts for the rich—that is what their plan amounts to.

Hilsenrath provides a few nuggets of hope that the Fed will spend more time thinking before embarking on another futile gesture:

Some Fed officials believe the central bank shouldn’t be favoring one sector of the economy—housing—over others, and thus shouldn’t be in mortgage securities at all…There are some practical reasons why a step toward mortgage purchases, if it happens, might not happen right away. In a parallel track to discussions about securities purchases, Mr. Bernanke is pushing the central bank toward more clearly and explicitly communicating to the public how the Fed reacts to changes in inflation and unemployment. It is a complicated debate that is unlikely to be resolved quickly. Officials might want to refrain from new bond-buying measures until that communication strategy is worked out.

In the meantime, expect continued stagnation, persistent joblessness, and growing social unrest.

Have a good weekend.

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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