FOMC to the QE?

With heated public debate and growing uncertainty about the momentum of the economic recovery, all eyes turned to the scheduled meeting of the Federal Reserve's monetary policy body (the FOMC) this week. Press reports that the Fed was reconsidering its exit strategy of unwinding its balance sheet had already come out on the heels of recent disappointing government reports (a disappointing slowdown in GDP growth from 3.7% the first quarter to 2.4% in the second quarter; weak labor market numbers in June and July; continuing signs of trouble in housing; plus persistent tight credit). Global recovery news has also been disappointing, with the eurozone fiscal crisis playing a role. Moreover, inflation has been coming in below the Fed's target range, according to some measures.

So, at Tuesday's FOMC meeting, the Fed changed its assessment of the outlook. In contrast to earlier in the year (and to some more hopeful economic commentators and politicians), its view now is that the recovery is slowing - not gaining traction- and that the risks are on the downside. Concern is more about the risks of deflation than inflation for the time being.

With increased concern about economic weakness, the FOMC announced that it would halt its plan to let its balance sheet shrink. More specifically, to maintain rather than withdraw support for the economy, it will reinvest the money from otherwise maturing mortgage-backed securities and agency debt in long-term Treasury securities. The move is intended to continue holding down long-term interest rates, which should help the mortgage market. These actions will also mean that the Fed is changing the composition of its holdings, back toward a greater relative weight in Treasury instruments - its more traditional holdings. While indicating only a modest change in support for the economy (only about 3.5% of Fed holdings of agency debt and MBSs will mature within a year), the FOMC also quietly indicated that it would be prepared to step in with additional resources if necessary. How much quantitive easing it would be willing to use, though, is unknown.

Financial markets responded yesterday with a reassessment of risk based on the Fed's statement and announced actions. Stocks took a hit and bonds rallied, presumably due to profit worries, safe haven interest and deflation concerns.

For fiscal policy wonks - whether you are taxpayers or politicians, the Fed's views and its even modest change in policy direction should give us food for very serious thought indeed. We have many challenges before us, many of which appear to go in a different direction - and at the same time. It is time to focus on the big picture for our country. An important part of this must be to try to get the fiscal and monetary policy mix right for the near future - but also beyond.

For the near term, we need a strong economic recovery - and there are signs that our financial sector-driven recovery may take more time than a "normal" recovery to gain its footing. Our labor markets continue to show signs of distress, which risk undermining economic momentum and even persisting into the future as more structural - not temporary - problems, which are very costly to a government and a society. Housing problems persist, which makes economic adjustment to a new normal growth path difficult to say the least. Fiscal tightening at the state and local level remains a drag on the economy.

Yet our fiscal house is out of whack. We face rising debt into the future as far as the eye can see. Events in Greece and other eurozone countries should be taken as a warning to the United States that markets eventually reach their limits of the amount of sovereign debt they'll finance - even if for the time being, having the dollar as the world's reserve currency might give us more running space. Like other countries, the United States needs to put our nation on a reasonable debt path - and we need a plan soon.

A fiscal package that supports the economy now but over time gets our fiscal house credibly in order, making the sorts of structural adjustments that encourage long-run economic success. The timing and composition of any package is important, with adjustment to our new fiscal path done gradually when the economy is on firmer footing. Putting high quality/growth friendly policies in place for the longer run can help boost standards of living for generations to come. We can do it smartly - or we can just cross our fingers and hope that this whole nightmare will just go away. Let's opt for the former.