Tags: Feldstein | Fed | taper | outlook

Harvard's Feldstein: By Not Tapering, Fed Created a 'Trap'

By    |   Tuesday, 24 September 2013 08:16 AM

By deciding not to taper its stimulus programs, the Federal Reserve "created a trap," and it will be difficult to change course unless it stops focusing on short-term data, Martin Feldstein, a Harvard economics professor and former chairman of the Council of Economic Advisers, writes in the Financial Times.

The Fed claims its monetary policy decisions are data-dependent. Last week, Fed Chairman Ben Bernanke reiterated this point, saying the Federal Open Market Committee (FOMC) could still decide to scale back quantitative easing (QE) this year if data confirms the Fed's economic outlook.

But Feldstein is skeptical of this strategy. The Fed has a history of being "too optimistic," he explains. And it's hard to reconcile multi-year forward guidance with policies that are sensitive to monthly economic news.

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At last week's meeting, the FOMC reduced its growth forecast, now looking for the U.S. economy to grow 2.0 percent to 2.3 percent this year, compared with its June growth projection of 2.3 percent to 2.6 percent.

According to Feldstein, if the economy is to pass the test, it must perform better than it has in any of the past three years.

Based on the official figure, the US economy only expanded 1.8 percent in the first half of 2013. Private estimates cite expectations for a similar rate in the current third quarter. Therefore, to reach the midpoint of the FOMC's range requires annualized growth of 3.2 percent in the fourth quarter, he notes.

The FOMC also reduced its growth forecast for 2014, now projecting 2.9 percent to 3.1 percent growth.

"As we get closer to 2014, the prospects for that year are likely to look weaker again," Feldstein predicts.

"The downgraded assessment of economic growth means that the economy is marginally further away from the point where the Fed would like to be when it begins to taper its monthly security purchases," John Silvia, chief economist at Wells Fargo Securities, writes in a market report.

Although the Fed claims to be looking for stronger evidence of progress, its also warns of risks, Silvia notes.

There's the possibility tighter credit conditions will hamper economic improvement and employment. And, rising interest rates could have a chilling effect on the housing market.

With after-tax income lower than it was a year ago and savings rates already falling, there's also the risk that consumer spending will be weak, Feldstein explains.

If the game plan is to taper based on the Fed's optimistic economic outlook, it's most likely the outcome will be another decision to continue quantitative easing at the current pace, he says.

But there is a way for the Fed to break free from the trap, Feldstein argues.

The central bankers could return to their previously stated recognition that the pace of bond buying should reflect a balance between the benefits and the costs to the economy. Doing so would require the Fed to start tapering next month and it could completely shut down the programs by mid-2014, he says.

At this point, bond buying has only minimal impact on economic growth or employment, Feldstein argues. And interest-rate policy is promoting risky behavior and boosting the risk of serious problems.

"The longer this process of abnormally low rates continues, the more disruptive will be the return to normal conditions," he wrote.

"It would be wise, therefore, for the Fed to shift away from its focus on short-term data, to recognize that it has achieved as much as monetary policy can do," Feldstein concludes.

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Related Stories:

Lawrence Lindsey: No Taper This Year, Rate Hikes to Be 'Disorderly'

WSJ: Bernanke's Decision Against Tapering Shows 'Failure of Nerve'

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By deciding not to taper its stimulus programs, the Federal Reserve "created a trap," and it will be difficult to change course unless it stops focusing on short-term data, Martin Feldstein, former chairman of the Council of Economic Advisers, writes in the Financial Times.
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2013-16-24
Tuesday, 24 September 2013 08:16 AM
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