The US Fed's summer of sequels

America's third consecutive summer slowdown will be wretchedly difficult to respond to, with policymakers limited to repeats of past stimulus options.

Here we go again. Summer in the US is a time for sequels. This year we have The Dark Knight Rises, The Amazing Spiderman, another Jason Bourne thriller, Men in Black 3, and an Avengers remake.

For the third year in a row we also have an economic slowdown. Payrolls growth fell to 69,000 new jobs in May. This slowdown may be the most wretchedly disappointing of them all, because the fundamentals have been looking better, and it will be wretchedly difficult to respond to.

All the policy options are sequels as well. Perhaps we could try Fiscal Stimulus 4, Operation Twist 2, Quantitative Easing 3, or another episode of Fixing Housing Finance, although most people have given up on that one because the rambling plot lines never seem to go anywhere.

This slowdown seems to be largely imported from Europe and the rest of the world, so US policymakers are powerless to tackle it at source. Some sort of fiscal action would probably be most effective, especially if it reduced uncertainty about tax and spending next year: the so-called fiscal cliff. Congress, however, is unlikely to risk giving anybody a victory before the election.

That leaves the Fed. On Thursday its chairman, Ben Bernanke, will testify to Congress on the economic outlook. As has happened often in the past five years, a routine hearing will turn into a crucial policy moment, setting expectations for the Fed’s policy meeting two weeks later.

Talk from the central bank has leaned away from further action. Ten days ago, William Dudley, president of the New York Fed, told CNBC he was "a little bit more confident that the economy’s going to keep growing” than in previous years.

But the situation is reminiscent of last August. All signals before that meeting were for policy to stay unchanged, not least because inflation was higher than in 2010, the last time the Fed acted, and was rising.

In the 10 days leading up to that August FOMC, however, came the debt ceiling debacle, an S&P downgrade of US debt, and market panic about growth. The meeting produced the Fed’s forecast of low rates "at least through mid-2013”. The next Fed meeting will conclude on June 20, three days after Greece holds more elections, and the potential for market turmoil is considerable.

That August 2011 meeting is also important for what it, and other recent actions, reveals about the Fed’s preferences. The central bank keeps trying to come up with a communication strategy to explain how it will respond to future data, but so far has failed. Hence its past actions are the best guide to the future.

Whenever markets cease to believe that inflation will be 2 per cent, or whenever the economy loses momentum such that unemployment no longer looks like falling, the Fed has reacted strongly. A break with that pattern – the economy’s main insurance policy – would be perilous.

"We will continue to assess, you know, looking at the economic outlook, looking at the risks, whether or not unemployment is making sufficient progress towards its longer-run normal level, and whether inflation is remaining close to target,” Bernanke said at his most recent press conference.

He also indicated that 100,000 new jobs a month might be the level that keeps unemployment flat, so that indicator is flashing red. Inflation expectations have remained fairly stable so far – reflecting the fact that this slowdown seems imported rather than homegrown – but they will surely drop if employment growth continues to stall.

If the Fed chooses to act, its main options are switching more of its existing investments into long-term securities, a so-called Operation Twist 2 – feasible and low-risk but plagued by diminishing returns – or it could buy more assets outright, most likely mortgage-backed securities, in a QE3.

That should be more effective, but might backfire if Republicans used QE3 as an election issue to attack the Fed, making markets question future policy stability. On Thursday, Bernanke may indicate which if any sequel he prefers.

Copyright The Financial Times Limited 2012.

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