August 12, 2003

Scorn for President Bush

The Economist explains the currently-limited power of monetary policy: Of course, what the Fed manages to convey about what it will do in the future is as important as what it does or does not do in the present. The FOMC has its hands on only the shortest of short-term interest rates--the overnight rate at which banks can borrow federal funds. Trimming a quarter point one way, or tacking a quarter point the other, is not in itself enough to steer America's huge economy. If the Fed wants to reduce the longer-term rates that really matter, it must not only get short-term rates down, as it has done, but it must also signal to the market that they will stay down. If the bond markets read and believe the Fed's signals, short rates will feed through into long rates almost immediately. That way, as Michael Woodford, a Princeton economist, puts it, the Fed can get the bond market to do its work for it.

But the bond market can also work against it, as it has done over the past month. Since mid-June, the yield on the ten-year Treasury bond has risen by almost 40%. The futures market was pricing in a rise in interest rates as early as January. That is nonsense, and the Fed's statement accompanying its decision on Tuesday should finally make that clear to the markets. With the economy running so far below its potential, the Fed still believes that inflation is more likely to fall than to rise. It also recognises that with inflation so subdued, the damage to the economy of a further fall in inflation would greatly outweigh the damage of a possible rise...

And it is scornful (in its understated, very British way) of President Bush's concentration over the past three years on long-run tax cuts that do little for short-run demand:

If monetary policy is on hold, what about fiscal policy? While the Fed governors were meeting in Washington, President George Bush was corralling his economic team together for a summit at his Texas ranch on Wednesday. Unfortunately, Mr Bush's fiscal ammunition is largely spent. His treasury, commerce and labour secretaries have just returned from a victory lap around the midwest to trumpet the $350 billion tax cut just passed by Congress. But the cut will only add to a budget deficit already forecast to hit $1.8 trillion over the next decade. One more victory like that and the fight for fiscal control will be lost. Mr Bush and his team have exhausted most of their legislative energy (not to mention the government's tax revenues) on measures they claim will improve the economy's supply-side potential, such as a cut in dividend taxes. Unfortunately for Mr Bush, the big economic challenge right now is not to improve the economy's productive potential, but to fulfil it. Funny that the Fed, which does not have to fight an election next year, seems to have grasped that point rather better than Mr Bush, who does...

Posted by DeLong at August 12, 2003 07:28 PM | TrackBack


I thought the editor of the Economist, was an American.

Posted by: big al on August 13, 2003 03:13 AM

So of course, the curve steepened markedly after the Fed released its statement. The simplest read is that the Fed instilled a bit more inflation/less deflation fear, except that most of that steepening resulted from a yield drop at the front end. We hear complaints that the Fed "failed" to do anything to steady the long end. Well, other than repeat the mistake of the May meeting, what can the Fed do but tell us rates aren't going to go up soon?

Posted by: K Harris on August 13, 2003 06:20 AM
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