Krause: Fed mistakenly signals a retreat on stimulus

Federal Reserve chairman Ben Bernanke?s long-awaited news conference

Federal Reserve chairman Ben Bernanke’s long-awaited news conference Wednesday hinted that later this year the agency may ease its bond-buying program that has kept interest rates near record lows. (June 19, 2013) (Credit: EPA )

The Federal Reserve is giving in to pressure from its critics to more quickly unwind its support for the economy -- increasing the risk that the recovery will be sidetracked, slowing growth and exacerbating the nation's employment problems.

The latest turn of events has its roots in the two policies the Fed used to stimulate the economy after the crisis of 2008. With the onset of the recession, the Fed pushed short-term interest rates to near zero and has held them there ever since. By 2009, the Fed had to do more and reached into its bag of tricks and began a series of bond-buying programs. The most recent one began last September, when the Fed started pouring more money into the economy by purchasing $85 billion in securities per month.

In December, the Fed announced an exit strategy: Its stimulus programs would continue until either the nation's unemployment rate fell to 6.5 percent or forecasts for long-term inflation rose to 2.5 percent. With the unemployment rate at 7.8 percent at the time, and inflation at 1.5 percent and falling, the consensus was that we were still years away from either one of these tipping points. By making its exit contingent upon improvement in the job market, the Fed was promising that it would keep its foot on the gas pedal until the job was done.


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And lo and behold, the policies seemed to work! The economy has showed signs of picking up, including increased job growth, an improving housing market, and stock indexes hitting new highs. Yet despite the good news, the Fed's critics have been warning that the stimulus has been excessive and likely to create disastrous side effects if not stopped.

I believe the detractors are mistaken. First, the Fed carefully calibrated its policies to fit the depth of the recession and then the anemic recovery that followed. For example, the latest bond-buying program was needed because Congress applied the fiscal brakes due to mounting debt and deficit worries. That forced the Fed to do more to prop up growth.

Second, the critics are wrong in fearing that the policies will produce economic disaster. They have predicted runaway inflation, new bubbles and a collapse in the dollar. But it has been five years and none of these things have come to pass.

Even more damning is that logic isn't on their side. Why should we expect an outbreak of wage and price inflation in the aftermath of the largest downturn since the Great Depression?

The critics have not given up. The latest scare scenario is a "malady" called "reaching for yield." They argue that by depressing interest rates and increasing the amount of money in circulation, the Fed's policies are pushing investors to take on too much risk in search of higher returns.

As proof, they point to the rise in stock prices. Undoubtedly, low interest rates have boosted stock prices, but it is normal for stocks to rise as the prospects for growth improve. That's something to cheer, not worry about.

Unfortunately, the Fed has bent to its critics, announcing last week that it intends to reduce its bond purchases later this year and then end them when the unemployment rate falls to 7 percent, from its current 7.6 percent. The Fed also signalled it will start raising interest rates once the unemployment rate reaches 6.5 percent.

U.S. and world stock markets tumbled on the news.

We can only hope that the markets overreacted in their reviews of the Fed's backtracking. But I fear the new timeline for tapering monetary stimulus will prove costly, and those in search of jobs will wait even longer, as the economy slows on its way to full employment.

That's a high price for trying to appease the critics.

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