The Opening Rift Within the Fed

Today's front page article in The Wall Street Journal (http://online.wsj.com/article/SB10001424052748703589804575446262796725120.html?KEYWORDS=Fed)
on the divergence of opinions within the Fed regarding the recent decision to prevent the gradual shrinking of its mortgage portfolio by reinvesting such proceeds in Treasuries, highlights a key undercurrent of the debate over this issue: that is, whether there is much the central bank can do at this point to prop up the struggling economic recovery.

The skepticism that was expressed by some FOMC members as to whether the Fed should proceed with the adoption of that measure at its most recent meeting was ostensibly based on the wisdom of assuming the risks implied by such action. The risks in question were not, at this stage, related to the injection of any additional liquidity into the system, but more to the implied message of lack of confidence that the Fed was expressing in the economic recovery's prospects. A directly associated risk was the perception that the Fed might be creating that this can be the prelude toward a second wave of asset purchases if the economic recovery continues to limp in the foreseeable future.

Perhaps underlying the skepticism as to the wisdom of proceeding with the announcement of the latest measure at the FOMC meeting is the premise that, after all, such steps are unlikely to make a real difference in reinvigorating economic activity. In other words, the unspoken message here is that a number of monetary policymakers do not essentially believe that there is much that the Fed can do to influence the direction of economic activity and any additional steps at this point are fraught mostly with risk and have no likely benefit.

The above is a view that we also share and have expressed in a recent article in this space (http://economistscorner.blogspot.com/2010_07_15_archive.html) but is one that is extremely difficult to be acknowledged by the Fed in public. It would be a highly problematic affair for a major central bank to openly state that there is not much left that it can do to jump-start a decidedly underwhelming economic recovery. It is in that context we should see the Fed's recent decision to reinvest the proceeds of maturing MBS securities in Treasuries and any other additional measure that may be announced in the coming months. It is more a reluctance to publicly acknowledge that its arsenal has been nearly depleted and that it will require quite some time until the economy and financial market conditions have fully healed from the highly traumatic experience of the last three years.

As Mr. Bernanke remains under steadily building pressure to show responsiveness to the recent "soft patch", he cannot afford total inaction, particularly if the upcoming stream of economic data remains unmistakably soft. As a result, the possibility of additional nominal measures by the Fed cannot be dismissed. However, such a course of action will, at the same time, almost guarantee a widening schism within the Fed and the opponents of that path are likely to become increasingly vocal. A taste of that became already apparent today with comments by Dallas Fed President Fisher, where he expressed skepticism as to whether the Fed will achieve anything with the new action it announced at the August 10 meeting or is simply "pushing on a string".

Mr. Bernanke has a very fine line indeed to walk on, between maintaining a posture of a Fed capable of still influencing the course of economic activity and causing a bigger rift within the institution that, at some point, can spill out into the open.

Anthony Karydakis