Thursday, December 03, 2009

Exit Strategies

The economy is growing again, but unemployment is extremely high and perhaps still rising (or if you prefer a positive spin, productivity is growing very rapidly). Inflation is not obviously lurking over the horizon, but memories of the Arthur Burns era are still fresh in the minds of Fed policymakers, and they fear that inflation expectations will become "unanchored".  Sooner or later the Fed will have to unwind its quantitative easing and raise short term rates.

Philly Fed President Charles Plosser says this should happen sooner:

Arguing that the U.S. economy has entered sustained recovery and forecasting growth rates of 3% for next year and 2011, Plosser said the Fed must take “appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available to the economy.”

This could include hiking rates from their current level near zero even “before unemployment or other measures of resource slack have diminished to acceptable levels.”

I have a very high opinion of Charles Plosser. He is an excellent and perceptive economist. I agree that Fed policy should be forward looking and that no one wants a return to the 1970s.

The traditional role of the Fed is supposed to be "to take away the punch bowl just as the party gets going," and Plosser's views are very much in that tradition (though in a much more sophisticated way).

However, the Fed runs the risk of "taking away the medicine before the patient has recovered" and to my mind, in this circumstance (i.e. worst recession in a long long time, arguably worse than 1982), that is the greater risk than the concerns outlined by Plosser. 

If I were a Fed President (YIKES!!), I guess I would make speeches like this one in public, but support leaving easing in place until unemployment and other measures of slack have turned the corner in private.

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