3 Reasons Why the Fed Won't Act This Week
Business + Economy

3 Reasons Why the Fed Won't Act This Week

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Unemployment remains stuck over eight percent and consumers are sitting on their wallets. The Euro-zone crisis grinds on with no real resolution in sight. And government spending policy remains paralyzed by divisive politics that threaten to send the economy over a “fiscal cliff” after the November election.

The uncertainty, born of political malfeasance on two continents, is real. The result is a U.S. economy that appears headed for a third straight year of sluggish economic growth in the wake of the financial meltdown of 2008-09.

That’s the unhappy backdrop for a two-day Federal Reserve Board meeting that gets underway on Tuesday. Since the Fed is the only government economic institution that operates with limited political constraints, those looking for a ray of sunshine amid the gloom are hoping the Fed will do something, anything to bolster the economy.
If you’re among them, get ready for a cold shower. Don’t expect any major moves when Fed chairman Ben Bernanke steps to the microphone on Wednesday afternoon to explain the Federal Open Market Committee’s latest policy pronouncement.

He will probably announce that Operation Twist – exchanging short-term federal debt in the Fed’s portfolio for long-term mortgage-backed securities – will continue beyond its June 30 deadline. That will ensure record low mortgage interest rates will continue for the foreseeable future.
But let’s not forget the recent past. Despite a few hopeful signs in the housing sector lately, low home loan rates haven’t resuscitated a market that is still plagued by underwater mortgages and high foreclosure rates.

The FOMC may also extend the Fed’s guarantee to keep interbank lending rates near zero for another year. The pledge currently runs through the end of 2014. But why should that do anything more than the earlier promise, especially given an environment where corporations are sitting on record amounts of cash and demand for their products is lagging? They don’t need lower cost loans. They need customers.

The Fed, as chairman Bernanke likes to remind Congress on his semi-annual visits to Capitol Hill, operates under a twin mandate. It must keep inflation in check. No problem there. With gasoline prices falling, inflation is well under the Fed’s two percent target.

And it is supposed to promote full employment, which has been defined as low as 4 percent unemployed in recent years. In a post-crisis environment, policymakers would be happy to get it down to 5 ½ to 6 percent.

Even though the jobless rate is far above that mark, don’t expect any bold new steps this week. Here are the three main reasons why the Fed won’t act:

1. The Slow-Boil Euro Crisis
With resolution of Europe’s sovereign debt woes up in the air, the Fed must keep its remaining powder dry to deal with a major meltdown. Last week, the world’s top central bankers signaled they would coordinate interventions to maintain liquidity if political events in Greece triggered capital flight by bondholders and depositors across the eurozone.

While Sunday’s election results gave a short-term reprieve from those fears, an even more important set of votes will be taken at the European summit at the end of this month. Rich countries of northern Europe, especially Germany, must decide if they’re going to create continent-wide policies to preserve the common currency. They would include a unitary deposit insurance system for European banks, coordinated fiscal policies across nations and coordinated actions to purchase sovereign debts.

The Fed along with the other central banks must be prepared to step in if Europe’s failure to take credible steps triggers an immediate crisis. “It begins and ends with Europe,” said Ted Truman, a former Treasury Department official and now a senior fellow at the Peterson Institute for International Economics. “Until we have a clear view, it would be risky for the Fed to throw a lot more” at the domestic economy.

What could the Fed do for Europe in a short-term crisis? It could step in and buy Euros from European banks, which would give them the wherewithal to step up their purchases of local government bonds. It could even buy European bonds directly. The Fed’s major holdings now are German bonds. Adding French or Dutch bonds to the portfolio (less controversial than buying, say, Italian or Spanish bonds) would be a vote of confidence that the European monetary union will eventually sort out its troubles.
2. Growth Has Slowed, Not Stopped
The signals on the domestic economy, while darker than they were a few months ago, remain mixed.  Macroeconomic Advisers recently lowered its consensus forecast for the second half of this year to 2.25 percent growth from 2.75 percent growth. While too low to substantially lower unemployment, it is far from signaling a double-dip recession.

“Consumers are not acting like they’re so spooked that they have to dramatically increase their savings,” said Joel Prakken, a senior managing director for the St. Louis-based group. The group has also lowered its forecast for the first half of next year, largely because of political uncertainty about how the White House and Congress will resolve the massive anti-stimulus that will hit in January if nothing is done.

3. Warning: Fiscal Cliff Ahead
With the resolution of the fiscal cliff up in the air, the Fed must be prepared to deal with political failure. Game theorists are having a field day spinning out scenarios for how Republican or Democratic control of the White House, House and/or Senate will deal with $3 trillion in expiring Bush-era tax cuts, $1 trillion in sequestration budget cuts and expiring tax credits. If political paralysis sets in, subtract anywhere from 3 to 5 percentage points from growth, that is, renewed recession.

“The economy is weak enough to justify Fed action already,” said Diane Swonk, the chief economist at Mesirow Financial in Chicago. “But fiscal policy is better suited to the problems we have right now.”

But what if the two parties can’t get together either before or after the election to compromise on a fix for the fiscal cliff that provides additional stimulus to the economy? “The Fed has to leave the door open to QE3 (quantitative easing or making large purchases of government bonds to stave off a systemic collapse),” she said, “either because we have a major crisis in Europe or the fiscal cliff.”