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Being half-right isn’t good enough when you’re Fed chief

Ben Bernanke and his buddies at the Federal Reserve have half the economic equation right. But the half they’ve got wrong could turn out to be quite costly.

In the Federal Open Market Committee  (FOMC) statement released on Nov. 3, the Fed reiterated its concerns over a slow recovery in output and employment; consumer spending being restrained in part due to high unemployment and modest income growth; a slowdown in business spending on equipment and software; weak investment in nonresidential structures; housing still being depressed; and employers reluctant to add jobs.

At the end of last month, the Bureau of Economic Analysis released its advance estimate of third quarter real GDP growth. It came in at

2 percent, barely ahead of the 1.7 percent rate in the second quarter. Since 1950, annual real GDP growth has averaged 3.4 percent. Over these past two quarters, growth averaged a mere 1.85 percent.

Since the current recovery supposedly got under way in mid-2009, real growth has averaged only 2.8 percent. Factor out recessions, and real GDP growth has averaged 4.5 percent since 1950 during recovery/growth quarters.

High-quality economic growth springs from the private sector, driven by entrepreneurship, investment, consumer choice and competition, as opposed to government’s share of GDP, with decisions guided by politics and special interests.

Unfortunately, once one factors out government’s contribution to real GDP growth, it turns out that private GDP grew at only 1.3 percent in the third quarter and 0.9 percent in the second quarter. The harsh economic reality is that the private sector has been barely staying ahead of a double-dip recession.

Bernanke and company opened the monetary floodgates in September 2008. The monetary base (currency plus bank reserves), which the Fed has direct control over, exploded by 150 percent from August 2008 to February 2010. Such a massive monetary expansion is without precedent in our nation.

Interestingly, a slight reining in of monetary policy occurred from February through September. But the Fed’s November statement makes clear the monetary policy floodgates will be opened still wider.

The FOMC said: “To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the committee decided today to expand its holdings of securities. The committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.”

The Fed believes that still looser monetary policy will somehow get the economy back on track. But how exactly would that work? Could interest rates actually be pushed any lower? After all, the federal funds rate is targeted at zero percent to one-quarter percent. A tiny reduction in interest rates from the current low levels will make no difference.

As should be apparent from the past two-plus years, monetary policy is not the right policy tool to aid economic growth and job creation. The Fed has been pressing the monetary policy accelerator to the floor, yet the economic engine continues to sputter and stall. Pushing even harder will accomplish nothing.

Well, at least nothing positive.

The enormous risk is inflation. In fact, the Fed chairman recently declared that inflation was too low, and the FOMC statement makes clear the Fed has adopted the old mistaken belief that a bit of inflation can help fight unemployment.

So, the Fed is adding to the potential economic ills. Rather than pulling in its recent monetary mistakes to perhaps stave off or limit the damage from future inflation, the Fed is moving in the exact opposite direction by further pumping up both monetary growth and inflation risks.

What the U.S. economy needs is straightforward. Monetary policy should be focused on maintaining price stability. Meanwhile, Congress and the White House need to rein in the size of government to free up resources for the private sector, and implement deep, broad-based tax and regulatory relief to boost incentives for investment and entrepreneurship, which in turn drive economic growth and job creation.

Unfortunately, monetary, spending, tax and regulatory policies have been pointed in exactly the wrong direction. The big question: Will this change with the historic shift that occurred on Nov. 2 at the ballot box?

— Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council

One comment

  1. Will it change with the Republicans in charge of the House? Not likely. They will not want to cut military spending, which is essential, or close the tax loopholes special interests have driven into the tax code. If I’m going to have to pay for graft, I’d rather pay for graft that ends up in the hands of individuals not mindless military imperialists, Boeing, Lockheed or other participants in the military machine including contractors who are not accountable to anyone. And close most of the off-shore (foreign) military bases. And return to a draft.

    Actually, this is a time for “equal hurt”. Place a $10.00/gallon “war tax” on gasoline to help pay for our wars, follow the Deficit Reduction Commission’s recommendations on reforming social security and Medicare, eliminate the housing tax deducion (yes!) and child tax credit (yes!) and raise taxes on every income level to pay off our debt in the next ten years (whatever it takes). Cut spending, increase taxes and balance the budget now, not leave this mess to our kids and grand-kids.

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