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Some at Fed Are Urging Pre-emptive Stimulus

Some Federal Reserve officials are reviving an idea that rose and fell with Alan Greenspan, the former Fed chairman, as they seek to persuade colleagues to take new action to stimulate growth.

Alan Greenspan
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Alan Greenspan

Central bankers generally set policy based on their judgment about the most likely path for the nation’s economy. But Mr. Greenspan argued that the Fed sometimes should do more than its forecast suggested, buttressing the economy against large, potential risks. He described such moves as “taking out insurance.”

On the eve of the Fed’s policy-making committee meeting on Tuesday and Wednesday, members who favor additional action argued that the likely path of the economy was itself sufficient reason for action. The committee predicted in June that without new measures unemployment would fall slightly, if at all, in the second half of the year.

But officials, including the Fed’s vice chairwoman, Janet L. Yellen, have sought to reinforce the case for action by arguing that the Fed also should seek to offset the looming risk that a European turndown will set off a global financial crisis, or that a failure to dismantle the potential year-end fiscal cliff of government spending cuts and tax increases will tip the economy back into recession.

“There are a number of significant downside risks to the economic outlook, and hence it may well be appropriate to insure against adverse shocks that could push the economy into territory where a self-reinforcing downward spiral of economic weakness would be difficult to arrest,” Ms. Yellen said in a June speech.

Laurence H. Meyer, a former Federal Reserve governor who, like Ms. Yellen, served under Mr. Greenspan, said that the return of “insurance” as a factor in the Fed’s decision-making was a necessary response to the current environment.

“There are many people who look at that idea and feel that this is what was done under Greenspan, and maybe this was one of the factors that led to excessive speculation,” said Mr. Meyer, now senior managing director at Macroeconomic Advisers, an economic forecasting firm based in St. Louis. “But when the downside risks have grown as large as they have become, I think you have to consider it.”

Proponents of new action continue to face resistance from officials who remain uncertain that the economy has lost momentum and would prefer to wait at least until the Fed’s next meeting in September. Ms. Yellen herself is not among the officials who have said publicly that they are convinced the Fed should act now.

The hesitation also reflects widespread concern about the waning potency of the Fed’s remaining tools, and about the cost of the most powerful measure, an expansion of its holdings of Treasuries and mortgage-backed securities.

The Fed also is under significant but counterbalancing political pressure in the midst of a presidential election. Republicans oppose additional action, which they describe as ineffective and likely to increase inflation, while Democrats want the Fed to do more.

Several leading analysts of the central bank predict that the Fed is most likely to take a relatively modest step on Wednesday, to show its concern while it awaits more economic data. The most likely action, they said, is an extension of the Fed’s forecast that interest rates will remain near zero at least until late 2014.

Sven Jari Stehn, an economist at Goldman Sachs, said in a note to clients on Monday that the Fed would extend that forecast to mid-2015. That would be more than a year beyond the term of the Fed’s current chairman, Ben S. Bernanke.

Mr. Greenspan described his approach to monetary policy in a 2004 speech in which he said that central banks are in the business of risk management, and that sometimes requires “insurance against especially adverse outcomes.”

He gave as an example the Fed’s response when Russia defaulted on its debts in 1998. The American economy was expanding, and Fed officials predicted that it would continue to do so. Some had been pushing Mr. Greenspan to tighten monetary policy. He did the opposite.

“We eased policy because we were concerned about the low-probability risk that the default might trigger events that would severely disrupt domestic and international financial markets, with outsized adverse feedback to the performance of the U.S. economy,” Mr. Greenspan said then. “The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario.”

Mr. Greenspan’s impressionistic approach to monetary policy was widely held in awe during his time atop the Fed, mostly because it seemed to be working. But his ideas lost considerable luster when the economy collapsed, and some concluded that he had suppressed and exacerbated the underlying problems.

Mr. Bernanke, in contrast to his predecessor, has pushed the Fed in the direction of transparent and predictable decision-making, which he says he regards as significantly increasing the Fed’s power by better controlling market expectations.

Some officials and economists also look askance at the idea of insurance because of the cost. It implies that inflation will be somewhat faster in the future.

And some see little reason to talk about insurance now.

Alan S. Blinder, a professor of economics at Princeton who was a Fed governor under Mr. Greenspan, said that the central bank should incorporate an assessment of less-likely risks into its decision-making.

But he added that there was little need for such nuances now.

“The Fed shouldn’t really be worrying about the finer points of risk management,” he said. “It should be hellbent on getting the unemployment rate down.”

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