The Fed is not Minding the Gap

It’s true, of course, that the Fed figures out the funds rate in light of inflation… but to some degree is also does so by measuring the “output gap,” the difference between what the economy — at full steam — could be producing and what it actually is producing.

Much of the output gap thinking is based on what Bloomberg columnist Caroline Baum refers to as the “debunked Phillips Curve,” which is supposed to describe the tradeoff between inflation and employment. Basically, that’s not something it actually does very well. And, despite the mathematical models intended to support the Fed’s rate analysis, the data collection and number crunching remain squishy at best.

From Bloomberg:

“The Fed is in no hurry to normalize short-term interest rates precisely for that reason [a theory that is only as good as our ability to measure]. The ‘likely continuation of substantial resource slack’ augurs for subdued inflation for some time, according to the minutes of the March 16 meeting released last week.

“Resource slack refers to excess capacity in both labor and capital. The unemployment rate has been stuck at 9.7 percent for the last three months, down from the cycle high of 10.1 percent in October. The capacity utilization rate […] at the nation’s factories, mines and utilities stood at 72.7 percent in February, well below its long-run average.

“Even if the CBO is correct and the output gap doesn’t close until 2014, there are risks to leaving the funds rate at zero for what the Fed says is ‘an extended period.’ Adjusted for inflation or inflation expectations, the real funds rate is negative. In other words, banks are being paid to borrow from the Fed and arbitrage the steep yield curve or make loans to businesses and households.”

The article goes on to point out that, “bank loans and leases continue to contract [… and f]or the moment, the $1 trillion banks are holding in excess reserves are staying put.” Once these excess reserves start circulating through the economy, the “Fed’s challenge is to prevent those reserves from fanning inflation.” Baum describes in a little more detail how she feels the Fed is doing on this front…

Again, from Bloomberg:

“To be sure, policy makers are aware of the risks; ‘they just view them as asymmetric,’ [chief economist at Pierpont Securities Stephen] Stanley says. ‘And they’re in a state of denial about the role of monetary policy in creating these bubbles.’

“Never fear. Our trusted regulators ‘noted the importance of continued close monitoring of financial markets and institutions — including asset prices, levels of leverage, and underwriting standards — to help identify significant financial imbalances at an early stage,’ according to the minutes.

“All clear for the moment, with no signs of ‘emerging misalignments in financial markets or widespread instances of excessive risk-taking.’ Phew. And here I thought we might relive the last crisis.”

Heh. The sarcasm here is strong… and for good reason. The Fed is in no particular hurry to raise interest rates, and with its “close monitoring” staff it still fails to see any “emerging misalignments” or “excessive risk-taking.” It’s a marvel how the US central bank can comfortably act from the same old and broken playbook… especially at this juncture in history, as inflationary pressures continue to mount.

You can read the full description of Baum’s reaction to the Fed minutes in Bloomberg’s coverage of how Bernanke’s exit plan may just fall through the gap.


Rocky Vega,
The Daily Reckoning