How the Fed and the Feds Are Becoming Irrelevant

Today's announcement by the Federal Reserve that it wasn't changing its zero to 0.25% target for the fed funds rate exemplifies the Fed's increasing irrelevance. It had no other choice. And, by all indications, it won't have any other choice for many months and maybe more than a year.

The Fed couldn't have raised rates. Even though doing so would have signaled growing confidence in the economic recovery and a revival of vigilance against inflation, a rate increase might well have dampened already modest economic growth.

But the Fed also can't lower rates. Although negative interest rates aren't literally impossible (a bank that charges fees on a checking account in excess of any interest it pays is imposing a negative interest rate), negative interest rates on a systemic level would erode the banking system as beleaguered savers horde pieces of green (and now sometimes brown) paper. In theory, the Fed could renew some of the asset buying programs it deployed at the height of the 2008 credit crisis (like buying mortgage-backed securities and even U.S. Treasury debt). But doing so would be tantamount to admitting that the sky is indeed falling. Programs meant to relieve a credit crunch might produce one.

Thus, the Fed is backed into a corner with very little room to move. It won't own up to its dilemma, since confidence in the central bank is the principal component of confidence in the banking system. It can only hope to use talk therapy to keep investors, depositors, and consumers from heading for the hills with water purifiers and freeze dried food.

The federal government can't be of much help. While there remains some stimulus money to be spent this and later years, the pipeline is shutting down. Populist politics is forestalling further stimulus legislation, even bills to extend unemployment compensation and federal assistance to the laid off to maintain health insurance under COBRA. These latter measures help America's working population--folks who in most cases will return to the work force sooner or later and whose productivity is essential to the future. Whatever the relative merits of compassion for wealthy bankers versus a helping hand for the middle class, it makes economic sense to prevent the worst consequences of unemployment from befalling those whose productivity is important for the future. Nevertheless, the politics of the hour may preclude even these modest measures. The populist backlash is making the federal government largely irrelevant to combating a likely economic slowdown.

The government's policy choices contributed greatly to the quagmire. The banking system's hundreds of billions of dollars of hinky assets weren't fully excised one way or another but instead were to a large degree papered over when Congress forced an easing of accounting standards. Tumors don't go away by themselves, and banks now horde cash instead of lending it, to protect themselves against losses from their continued large holdings of doggy assets. The financial system was saved from collapse, but it is now doing precious little to help the real economy recover.

European government spending is slowing down, and China will take its sweet time re-valuing the yuan. When you look around, there isn't any obvious impetus for a strong recovery. While you shouldn't panic yet, it might not be a bad idea to quietly look into water purifiers and freeze dried food.