Three former officials of the US central bank said that the US economy is at risk of falling back into a recession and that the Fed should consider taking more action in order to help the economy get back on track.
By Luca Di Leo and Jon Hilsenrath
August 3, 2011, 1:10 PM ET
Wall Street Journal Blogs
The U.S. economy faces a risk of falling back into recession and the Federal Reserve might need to consider a new round of securities purchases to deal with it, even though it isn’t in a strong position to address a slowdown, three former top officials at the central bank said.
In an exclusive interview with the Wall Street Journal, Donald Kohn, Vincent Reinhart and Brian Madigan – the last three directors of the Fed’s powerful monetary affairs committee — put the risk of a new economic contraction at between 20% and 40%. Madigan and Kohn said the Fed should consider a third round of bond purchases only if inflation slows from recent elevated levels and if the economy continues to underperform. But they cautioned a new purchase program, dubbed QE3, would not represent a cure-all.
Madigan, who advises Barclay Capital and teaches at Georgetown University after retiring from the central bank a year ago, said the Fed’s $600-billion bond purchases that ended in June had a “relatively modest” positive effect on the economy. “Purchases of that order of magnitude could be helpful at the margin,” he said in his first public interview since leaving the key position at the Fed.
Kohn was the most optimistic, saying the odds of a new recession following the severe downturn of 2008 and 2009 stood around 20%. Kohn, the Fed’s no. 2 official until Sept. 2010, still believes the economic slowdown in the first half was mainly due to temporary factors such as high food and gas prices and the impact of Japan’s earthquake on the global supply chain. But even he’s starting to lose faith in this forecast.
Fears that a new recession may be around the corner are hitting global financial markets and sent U.S stocks down for the ninth straight session Wednesday. U.S. consumers cut spending in June at the fastest pace in nearly two years, raising concerns that the economy is stalling largely because of underlying weakness following the financial crisis, not one-off factors. Economists have started to downgrade their forecasts for faster growth in the second half, after gross domestic product rose by less than 1% in the first six months of the year.
Kohn said the Fed still has some options to support the economy, but “they’re kind of limited”. He expects the central bank, which holds a policy meeting Aug. 9, to wait and see whether the recovery is really losing steam before taking any action. If that’s the case — and inflation is coming down — then he’d give “very serious consideration” to a new round of bond purchases.
The bond purchases can help the economy by keeping borrowing rates, which are tied to U.S. Treasurys, low and by driving investors to riskier assets like stocks. But they’ve been attacked by Republicans at home and foreign government officials for fear they’ll spark runaway inflation and have lead the U.S. dollar to lose too much value.
Fed Chairman Ben Bernanke told Congress last month that he’s prepared to act if economic weakness persists. But he’s also signaled that, in order to buy more bonds, the Fed must see a risk of deflation. Though there have been hints that consumer prices are cooling off, many measures of inflation remain above the Fed’s informal target of close to 2.0%.
The U.S. government’s jobs report for July, to be released Friday, is expected to show the unemployment rate to have remained at a lofty 9.2%. Total nonfarm payrolls are forecast to have increased by only 75,000 last month, with continued layoffs seen in state and local governments.
While relieved that a government default was avoided, the former Fed officials were critical of a deal approved by Congress Tuesday that allows the government to borrow more now in exchange for budget deficit cuts of as much as $2.4 trillion over the next decade.
Reinhart, who said he gives Congress “a very low grade” like most Americans, believes the odds of a credit downgrade by rating companies have not changed following the debt deal. Standard & Poor’s was looking for 10-year budget cuts of $4.0 trillion to confirm the U.S. top-notch AAA rating.
Kohn noted the deal leaves lots of uncertainty over the path of fiscal policy, making it harder for the Fed to decide what to do with monetary policy. The debt deal doesn’t specify what happens to the payroll tax cut enacted in Jan. and passes on the key long-term decisions of cutting the deficit to a bipartisan committee.
While more bond purchases could help the U.S. economy at the margin, Madigan said that providing more explicit guidance on how long the Fed’s short-term interest rate remains close to zero — another easing option mentioned by Bernanke — would not be so effective.
The Fed funds rate, or the rate at which banks lend to each other overnight, will probably stay at a record low at least until the middle of 2012, according to both Madigan and Reinhart. The Fed drove the rate down to zero at the end of 2008 to fight the financial crisis, leaving it with fewer ammunitions to lift the economy.
“We’re flying the plane slower and closer to the ground, so we’re less resilient to adverse shocks,” said Reinhart, who puts the odds of a new recession at 40%. Following a financial crisis, seven out of 15 countries studied by Reinhart have experienced two recession over a 10-year period.
To see original article CLICK HERE