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Fed Won’t Stop Presses if it Derails Recovery

Irwin M. Stelzer

There is a great tendency both here and abroad to concentrate on the entertaining features of American politics:

  • A president who decides to launch a charm offensive by which he means making his person available to a few Republican congressmen for a timed dinner;
  • A Tea Party that finds multiple ways of saying “no new taxes” while nevertheless considering “revenue enhancements;”
  • Republican politicians jousting for their party’s nomination to take on Hillary Clinton in 2016;
  • A Democrat leader in the Senate who refuses to allow a vote that would prevent the closure of several airport control towers by redirecting funds from the purchase of new uniforms for airport security personnel;
  • An administration that churlishly responds to spending cuts by ending school kids’ tours of the White House while funding a presidential trip for a round of golf with Tiger Woods.

Dig beneath such reports and a different, more serious and more promising picture emerges, at least on the fiscal front. For the first time in four years Senate Democrats have produced a budget. It differs substantially from the House Republicans’ version, but it sets the stage for a negotiation that just might succeed.

Republicans have agreed to allow spending to rise at an annual rate of 3%-4% (close to Obama’s current 5%), and to cap military spending, which pleases the president, who says he is willing to curtail the cost of the long- term healthcare and pension entitlements that Republicans fear will convert America into another Greece ere long.

And before scampering back to their constituencies during the Easter recess, both parties agreed to include the $1 trillion, 10-year cut forced on them by the “sequester,” in the bill funding the government for the next year.

Both parties agree that some of the give-aways in the tax code must be eliminated, but differ as to whether the enhanced revenues should be spent or used for deficit reduction. Charles Krauthammer, a much listened-to Pulitzer prize-winning columnist, suggests the funds from tax reform be divided evenly between deficit reduction and new spending, a Solomonic solution that many in Washington think might find its way into a “grand bargain” if the president puts his muscle behind it, even though it emanates from a conservative. The road to this chimerical bargain remains rutted, but it might be passable.

All of this is playing out against some little-noted progress. The president’s rout of House Republicans in the battle of the fiscal cliff produced an increase in taxes on “the wealthy” that will bring an additional $700bn into the Treasury over the next decade. If the caps imposed on spending by the sequester hold, spending will come down by about $1 trillion compared with the levels that would otherwise have prevailed. These cuts in Washington that means lesser increases in planned spending are on top of $1.5 trillion in spending reductions agreed by the president and the Congress in 2011. Throw in the lower borrowing costs associated with these lower deficits and you have reductions of almost $4 trillion that will bring the deficit down to about 3% of GDP, a level most economists consider sustainable. The Congressional Budget Office estimates that this year’s deficit will come to $845bn, or 5.3% of GDP, half the level in 2009. True, the cuts and tax increases are not falling where they might best contribute to growth, but they are bringing the deficit down, at least until the cost of Obamacare and the demands of the baby boomers hit the budget some years hence. So fiscal policy is less of a train wreck than it was only months ago.

Which brings us to monetary policy, and Federal Reserve Board chairman Ben Bernanke’s insistence on printing money $85bn a month so long as the unemployment rate remains stuck above something like 6.5%. Or until he is convinced that the fiscal tightening described above will not do to the US economy what austerity has wreaked on the Greek, Spanish, Portuguese and (some say) British economies.

We are now in the third round of such quantitative easing, or QE3, which is keeping interest rates down and home-buying and share prices up. Bernanke takes credit for preventing the economy from sinking back into recession, and, were he less modest, he also might claim to be the role model for Mark Carney, the new governor of the Bank of England, and Haruhiko Kuroda, the new head of Japan’s central bank among others. All are captains of their nations’ QE, battling recessionary headwinds and heading, they hope, for the calm waters of sustainable non-inflationary growth.

Until now, little attention has been paid to just how the Fed might bring this era of easy money to an end. Now, the Fed has changed its policy from we “will” continue buying $85bn per month to it has “decided” to do so, subtly suggesting that at some point it will decide not to. Bernanke has already said he will respond to “changes in the outlook.” And William Dudley, president of the Federal Reserve Bank of New York, wants to “calibrate” the speed of the Fed’s printing presses to “material changes in the labour market outlook.”

Small problem: the Fed has consistently overestimated future growth by a non-trivial 1.4 to 1.9 percentage points, according to former White House chief economist Larry Lindsey. So if the Fed does regulate the volume of purchases to its “outlook,” it is more likely to cut too much too soon rather than too little, too late bad news for those who are enthusiastically stocking up on shares, and good news for those who believe the Fed is stoking future inflation by not phasing out its purchase programme right now.

But don’t start dumping shares or looking for that new house. The Fed wants proof that Obama’s tax increases and Congress’s spending cuts won’t derail the not-yet-robust recovery. Until then, the presses will roll, and interest rates will cause continued gnashing of teeth by frugal savers in search of yield.

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