The Fed Doubles Down

September 25, 2012

The Federal Reserve is working tirelessly to increase economic growth and reduce unemployment. According to a recent statement by the Federal Open Market Committee (FOMC), the Fed's new conditional approach allows it to affect real variables like the level of unemployment by precommitting it to further action if goals are not met and precommitting it to maintain a highly accommodative policy stance, says John H. Makin, a resident scholar at the American Enterprise Institute.

At a glance, the FOMC statement looks like another round of quantitative easing:

  • The Fed will purchase mortgage-backed securities at $40 billion per month.
  • Additionally, the existing Operation Twist measures will continue as an attempt to push down long term interest rates.

However, the difference between quantitative easing and what the Fed says in the statement is that the FOMC will monitor economic and financial conditions and if the labor market does not improve substantially, the committee will "employ its other policy tools as appropriate until such improvement is achieved in a context of price stability." This allows an extreme amount of flexibility for the Fed, which means that:

  • The purchase of assets and use of other tools will continue until the labor market improves.
  • Furthermore, it assumes there is no possibility of failure, as asset buying will continue until the market improves.
  • Also, there is ambiguity about the response to asset buying in the case of a rise in inflation.
  • Finally, the Fed expects that a highly accommodative stance will go on for at least three years.

The Fed's bold strategy represents a high-risk, high-reward type situation. If inflation doesn't rise and the economy picks up, the banks are in for good news as the Fed will be able to hold down short term interest rates. However, if the Fed tries to hold down long term rates while the economy is recovering, the risk of inflation is greatly enhanced.

Source: John H. Makin, "The Fed Doubles Down," American Enterprise Institute, September 13, 2012.

 

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