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SHOULD THE FED EASE MONETARY POLICY FURTHER?

I’ve been fairly clear about my opinion that the Fed is just about out of bullets here. Aside from extreme policy options, most of which will ruffle political feathers, the Fed’s options just aren’t that robust at this point given the uniqueness of the environment. Goldman Sachs, however, has a different perspective. This note, courtesy of FT Alphaville, describes why Goldman believes the Fed should continue to ease:

Q: Should Fed officials ease monetary policy further?

A: Yes, we think so.

“There are two main arguments against further easing, but we don’t find them very compelling. The first is that “QE2 didn’t work, so why should QE3 be any better?” We disagree with the view that QE2 didn’t work. It is true that QE2 failed to ignite a more powerful recovery. However, we would attribute this to the combination of an even more adverse “baseline” pace of growth than we (and the Fed) had expected, and to the increase in oil prices. Moreover, our commodity strategists believe that most of the increase in oil prices was due to the tightening demand/supply situation in the oil market, exacerbated by the turmoil in the Middle East. Our belief that the moves in oil prices have been mainly driven by supply and demand rather than monetary policy is also consistent with the easing in oil prices over the past few weeks–a period in which the economic indicators have deteriorated and expectations of QE3 have grown.

The second argument against further easing is that most of the problems in the economy are not easily addressed by monetary policy but require either fiscal solutions or simply time. We agree that monetary policy is unlikely to be very powerful, but we do think that it would add a few tenths to GDP growth and would not have significant costs in terms of inflation given the large amount of slack in the economy (see “How Much Growth Boost to Expect from QE3?” US Daily, August 24, 2011). Ultimately, the question whether to ease is a cost-benefit calculation, and the benefits exceed the costs in our view.”

This opinion obviously doesn’t mesh with my belief that QE2 did little to help (and in fact may have hurt) or that the Fed is out of bullets. It reminds me a bit of what my father (a former Marine) used to jokingly to say to me and my brothers and sisters when we were little:

“The beatings will continue until morale improves!”

This incessant hope based policy approach is like hoping morale improves via confidence fairy economics, “wealth effects” and other approaches that don’t attack the structural problem and instead target the symptoms. And boy do these beatings hurt (and no morale is certainly not improving if recent consumer confidence figures are any indication). We’re almost 4 years into this recession and it still stings! When will we get the message?

Why do I believe it’s time to give up on monetary policy? Because this incessant praise of the Federal Reserve and this myth of the all powerful man behind the curtain is highly damaging. Not only does it feed the theme of financialization in this country, but it also detracts from the real policy debate we should be having. And that debate should be revolving almost entirely around fiscal policy. Instead, because we think the Fed still has bullets in their water canon, we ignore the other much more powerful options we have. Options, that will actually work in a balance sheet recession….

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