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Fed misdiagnoses economy, then prescribes a placebo

When a patient walks into a doctor's office complaining of a chronic condition, the first thing the physician does is take a medical history.

When did the symptoms start? Describe them. Have they gotten better or worse? Have you consulted a doctor previously, and if so, what did he prescribe? What was the response?

When the economy is sick, a correct diagnosis is equally important in determining the course of treatment.

On the fiscal-policy side, the Obama administration and members of Congress can't agree on whether the U.S. economy's problem is too much debt or too much unemployment. At least they agree on the "too much" part.

Central bankers at the Federal Reserve examined the patient and came to a different conclusion about the economy's malaise. At the Aug. 9 policy meeting, officials determined that the problem is the rate structure: Specifically, long-term interest rates are too high. In order to bring them down, some verbal tinkering was in order.

The Fed said economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013." This is the first time since the introduction of the "extended period" language in March 2009 that the Fed has assigned a specific time frame to it.

The truth is, the Fed doesn't know how long it will need to keep the funds rate at its current setting of zero to 0.25 percent. In early 2010, the central bank was readying an exit strategy from a period of monetary accommodation. With each piece of old news, its growth forecasts have been revised down, and its unemployment forecasts up. This is why I call them "hindcasts."

That's not to say the Fed's projections are worse than those of your average Wall Street economist or average Joe. It's just that the central bank controls the monetary levers. Unlike the rest of us, it has the tools to convert its forecasts into reality.

At the same time, actions predicated on forecast mistakes have consequences. The Fed was still worried about deflation as late as 2003, leaving the funds rate at 1 percent for too long and inflating the housing bubble.

From the three options that Fed Chairman Ben Bernanke outlined previously should the economy need an additional transfusion -- additional long-term securities purchases, a reduction in the interest rate paid on excess reserves and verbal gymnastics -- the Fed picked the third, which is also the silliest. And it's right off the shelves of academia, where rational-expectations theory is an obsession.

Bernanke explained the goal of such a strategy in a speech at the Kansas City Fed's annual Jackson Hole conference last year. Modifying the language in the statement "to communicate to investors that it anticipates keeping the target for the federal funds rate low for a longer period than is currently priced in markets" would "presumably lower longer-term rates," he said.

When was the last time you heard a friend complain that high mortgage rates were standing in the way of a home purchase? Last week, the rate on 30-year fixed-rate mortgages was 4.4 percent. With Treasury yields diving after the Federal Reserve's statement, that rate could approach 4 percent, where it was in November. The housing market was lifeless then, and there's no reason to expect lower mortgage rates to ignite the residential real-estate market when an overhang of debt is the problem.

The Fed's two-year promise of zero interest rates isn't without consequences. What happens during the next inflation scare? If there is one thing the Fed fears more than actual inflation, it's inflation expectations that break loose from their moorings.

Some economists suspect that last week's verbal gymnastics are a prelude to some form of renewed action on the part of the Fed. (See options one and two above.) Three members of the policy-making committee, all presidents of Federal Reserve banks, dissented from the Fed's action, or wordplay as the case may be. They preferred to retain the extended-period-without-a-date language.

The last time there were three dissents was on Nov. 17, 1992, according to Ward McCarthy, chief financial economist at Jefferies & Co. That was during another period of low official interest rates (at the time, 3 percent was considered low), sub-par economic growth (at least before data revisions), modest yet accelerating job creation and record budget deficits ($290 billion in fiscal 1992).

Compared with the current metrics, the 1990s probably look like nirvana to the Fed. Back then, the drug of easy money was enough to restore the economy to health. Today's economy would appear to be drug-resistant. More likely, it's suffering from a different and more lethal disease.


Caroline Baum, author of "Just What I Said," is a Bloomberg View columnist.