Cost of Fed’s potential policy ‘taper’ may be jobs

Talk of slowing the purchase of long-term bonds might risk the economic recovery

Federal Reserve Chairman Ben Bernanke – the  Federal Open Market Committee’s talk of slowing long-term bond purchases has effectively  tightened monetary policy

Federal Reserve Chairman Ben Bernanke – the Federal Open Market Committee’s talk of slowing long-term bond purchases has effectively tightened monetary policy


This week the Federal Reserve’s Open Market Committee – the group of men and women who set US monetary policy – will be holding its sixth meeting of 2013. At the meeting’s end, the committee is expected to announce the “taper” – a slowing of the pace at which it buys long-term assets.

Memo to the Fed: Please don’t do it. If you think about the balance of risks, this is a bad time to be doing anything that looks like a tightening of monetary policy.

Okay, what are we talking about here? In normal times, the Fed tries to guide the economy by buying and selling short-term US debt, which lets it control short-term interest rates. Since 2008, however, short-term rates have been near zero, which means they can’t go lower (since people would just hoard cash instead).

Yet the economy has remained weak so the Fed has tried unconventional measures, mainly by buying longer-term bonds, US government debt and bonds issued by federally sponsored home-lending agencies.

Now the Fed is talking about slowing the pace of these purchases, halting them sometime next year. Why?

One answer is the belief that these purchases – especially purchases of government debt – are, in the end, not very effective. There’s a fair bit of evidence to support that belief, and for the view that the most effective thing the Fed can do is signal that it plans to keep short-term rates, which it really does control, low for a long time.

Tightening monetary policy
Unfortunately, financial markets have

decided that the taper signals a general turn away from boosting the economy. Expectations of future short-term rates have risen sharply since taper talk began, and so have crucial long-term rates, notably mortgage rates. In effect, by talking about tapering, the Fed has already tightened monetary policy a lot.

But is that such a bad thing? That’s where the second argument comes in: the suggestions that there really isn’t that much slack in the US economy, that we aren’t that far from full employment.

After all, the unemployment rate, which peaked at 10 per cent in late 2009, is now down to 7.3 per cent, and there are economists who believe the US economy might begin to “overheat”, to show signs of accelerating inflation, at an unemployment rate as high as 6.5 per cent. Time for the Fed to take its foot off the gas pedal?

I’d say no, for a couple of reasons.

First, there’s less to that decline in unemployment than meets the eye. Unemployment hasn’t come down because a higher percentage of adults is employed; it’s come down almost entirely because a declining percentage of adults is participating in the labour force, either by working or by actively seeking work.

And at least some Americans who dropped out of the labour force after 2007 will come back in as the economy improves, which means we have more ground to make up than that unemployment number suggests.

How misleading is the unemployment number? That’s a hard one, on which reasonable people disagree. The question the Fed should be asking is, what is the balance of risks?

Full employment
Suppose, on one side, that the Fed were to hold off on tightening, then learn that the economy was closer to full employment than it thought. What would happen? Well, inflation would rise, although probably only modestly. Would that be such a bad thing? Right now inflation is running below the Fed’s target of 2 per cent, and many serious economists – including, for example, the chief economist of the International Monetary Fund – have argued for a higher target, say 4 per cent. So the cost of tightening too late doesn’t look very high.

Suppose, on the other side, that the Fed were to tighten early, then learn that it had moved too soon. This could damage an already weak recovery, causing hundreds of billions if not trillions of dollars in economic damage, leaving hundreds of thousands if not millions of additional workers without jobs and inflicting long-term damage as more of the unemployed are perceived as unemployable.

The point is that while there is legitimate uncertainty about what the Fed should be doing, the costs of being too harsh exceed the costs of being too lenient. To err is human; to err on the side of growth is wise. One of the prevailing economic policy sins of our time has been allowing hypothetical risks, like the fiscal crisis that never came, to trump concerns over economic damage happening now. I’d hate to see the Fed fall into that trap.

My message is, don’t do it. Don’t taper, don’t tighten, until you can see the whites of inflation’s eyes. Give jobs a chance.

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