- The risk of a recession if we taper too soon.
- The risk of deflation.
- What policy tools exist beyond quantitative easing or “QE”.
Bernanke has been rattling the markets with all his taper talk. The last thing the Fed wants is a Pavlovian response that every time the central banker talks, markets tank.
So Wednesday’s press conference likely will be about soothing the markets, providing clarity on the tapering timeline, and highlighting positive economic news, such as the recent jobs report. (See Pethokoukis’ wet blanket on the job report).
Businesses, investors, and municipalities who care about what could happen to the economy once tapering begins will have to look elsewhere.
AEI scholars John Makin and Desmond Lachman discussed the possibilities of a recession, deflation, and costs of continuing QE in a conference call on June 26, 2013. Below are their insights to supplement what you won’t hear today.
Let’s say, hypothetically, that the Fed tapers. Do you think there’s a high risk of recession?
John Makin: Yes, I do. In my own mind, we still have fiscal drag from higher taxes and the sequester which isn’t fully phased in yet. So, if you step back and say, “Look, the economy can’t get past 1.9 to 2% growth and we’re tightening fiscal and monetary policy and the global economy is weak, why should the recovery accelerate and why should we grow at three percent?” On top of this, we would have higher interest rates, probably a threat to the housing recovery, and lower stock prices.
Desmond Lachman: If the Fed waits for the economy to be showing momentum for unemployment to be coming down with favorable conditions then the chances of tapering successfully without inducing a recession are heightened.
I would say that the risks of moving into recession are not high if we were to confine ourselves to looking at the US in isolation. My concern would be more the trouble you might be getting from Europe. We might get a shock of that sort for which we are not prepared.
So, my answer would be conditional, depending on what are the conditions prevailing at the time that the Fed starts tapering. And my expectation is that the Fed will only start tapering when it sees the economy having sufficient momentum and unemployment coming down. And I do not expect to see those conditions occurring anytime soon
How big of a risk is deflation?
John Makin: I think saying deflation, outright deflation, is a risk in the United States is perhaps pushing it a bit. But disinflation to year-over-year and price changes of below one percent brings us kind of into deflation scare territory.
I think it was odd that the Fed dismissed that notion by saying, “Well, these lower inflation rates we’ve seen are a temporary factor or related perhaps to a drop in medical costs and others.” I don’t see any evidence for that.
So, if I take the possibility that, you know, the dollar strength in the economy is slowing, interest rates are higher, that adds to the disinflation risk and will certainly compound the Fed’s problems if the economy slows.
Desmond Lachman: Not looking at the United States but looking in Europe, there’s clearly a risk of deflation. If you look at core inflation in Europe it has now come down to 1% and you’re getting actual deflation in places like Greece, where prices are now falling and that of course is hugely problematic.
If you get deflation in Europe, it’s going to make it all but impossible for many of these highly indebted countries to get out of their debt problem. The deflation adds to the burden of the debt and that’s why it has to be very much regretted that the ECB, at its last meeting, self-constrained not to do anything. So, this is really troubling in Europe. There’s a real scare of deflation and at the same time, you’ve got an ECB that is highly constrained at least through October.
Is the cost of QE greater than the benefits?
John Makin: One of the costs of QE that has been put forward over the past several years has been that, well, we’re going to have higher inflation and we have lower inflation. I have a hard time with that problem. Then the other is, well, you know, when the bubble bursts, it’s only going to be worse the more we keep pushing it up.
It’s going to be difficult, but to say that is going to be painful to exit the accommodative policy, it doesn’t translate into the idea that, “Well, let’s do it when the US economy is slowing, the world economy is weak, and let’s see if the economy can stand higher interest rates and less wealth creation.”
I don’t follow that. I think the burden of proof is on those, you know, like Bullard and others on the FOMC who said, you know, terrible things are going to happen if the Fed continues this.
Desmond Lachman: I certainly agree with John that you don’t want to start the tapering right now. But the way I see it is there is a tension between when you want to exit and what you’re doing to asset pieces in general.
The longer that you keep pumping additional money in – the Fed is not doing it by itself, it’s got the Bank of Japan revving up and likely the Bank of England will join in later – that pushes asset prices up. So the further you push up those asset prices, when you do exit the bigger the danger that you’re going to have a nasty correction going forward.
There is a tension there. You want to get out of QE3 as soon as you can but you don’t want to do it if it’s really going to sink the economy because this is really your last shot that you’ve got to get the economy back on a good track.
Excerpts are taken from the AEI conference call, “Discussion on QE tapering and market turmoil,” featuring AEI scholars John Makin and Desmond Lachman on June 26. If you would like to be included in future calls, please contact Abby McCloskey at firstname.lastname@example.org.
Want to learn more about QE? Here’s some beach reading:
The White House sends a wake-up call to the Fed, John Makin, July 9, 2013
QE undone, John Makin, July 1, 2013
How to predict the Fed, Steve Oliner, June 17, 2013
QE: A guide for the perplexed, Steve Oliner, May 29, 2013
Mr. Bernanke needs to be replaced, Desmond Lachman, June 20, 2013
AEI scholars react to FOMC statement, Abby McCloskey, June 20,2013
Oldie but goodie: QE in Theory–and Practice, Vincent Reinhart, March 09, 2011
Troubling taper talk from central banks, John Makin, June 26, 2013
The Fed can’t save the stock market again, John Makin, May 21, 2013