Fed should stand ready for third round of stimulus

The Federal Reserve’s efforts to help dollar-starved European banks have pleased global investors, but the central bank’s moves can only temporarily distract attention from a dilemma back home: what to do about the exceedingly weak U.S. recovery.

Lately, the patient has shown tentative signs of improvement. Today, the Labor Department announced that the unemployment rate fell to 8.6 percent in November, the lowest since March 2009. Nonfarm employers added 120,000 jobs. Pending home sales are up. Retail sales are rebounding. Consumers are a bit more confident.

The improvements, though, come from a dismally low base. The U.S. labor market is still weak, with new unemployment claims rising and more than 13 million people actively looking for work. The jobs figures in November were not all good: The fall in the unemployment rate was bigger than expected because 315,000 Americans dropped out of the labor force.

External trends are discouraging. Though Europe’s leaders may be making progress toward resolving their sovereign-debt crisis, the region’s economy ― which accounts for about a fifth of U.S. exports ― is already headed toward recession. The Paris-based Organization for Economic Cooperation and Development expects growth to decelerate in Canada and Mexico, too.

The Fed also has to deal with an abrupt, and partly unintended, tightening of U.S. fiscal policy. Stimulus spending was fading to begin with. Now, the failure of the congressional supercommittee to reduce the budget deficit means extended unemployment benefits and cuts in payroll taxes may not be renewed for 2012 ― let alone expanded, as President Barack Obama’s jobs bill proposed. Even if agreement can be reached to maintain fiscal supports, it’s likely that the cost will be met by tax increases and spending cuts elsewhere, neutralizing the needed short-term macroeconomic lift.

All this means new monetary stimulus must not be ruled out. With U.S. short-term interest rates as low as they can go, the stimulus would have to be done through a fresh round of the bond buying known as quantitative easing. The policy has risks, to be sure, but in current circumstances there are no safe remedies.

Fed Vice Chairman Janet Yellen recently argued that a third round of easing might become necessary. The recovery has been slow and is not yet secure, she emphasized. Risks are loaded on the downside. The central bank has to remain attentive to the dangers, and be ready to act. We agree.

Many argue that quantitative easing is a spent force. Admittedly, with interest rates so low, it is a diminished one. But rates aren’t the only channel through which the strategy operates. Asset purchases can support demand by dispelling fears of deflation ― the most contractionary force known to economics. If successive rounds of bond buying have to be bigger to achieve the same effect, so be it.

Others argue that easing was ineffective in the first place, or that it is bound to spur inflation. While it is early days for a definitive account of the plan’s success to date, economists tend to agree that where it has been tried, it has helped.

In any event, the view that further expansion of the Fed’s balance sheet would necessarily fuel inflation is wrong. Should the danger arise, the Fed can pull money out of the economy by raising the interest rate it pays on reserves. Ultimately, the central bank can shrink its asset holdings.

The fierce political argument surrounding the Fed makes the issue of whether to stimulate all the more difficult. It is one thing for members of its board to have good-faith disagreements over policy ― though that already compromises the Fed’s ability to explain itself to the public. It is quite another for Republican members of Congress and presidential candidates to repudiate the very principle of central-bank independence and make barely veiled threats of reprisals should the Fed adopt a policy they oppose.

If you want unsound central banking, that is how you go about it. Get the Fed under the thumb of Congress. The rest follows.

With a lot of luck, the economy will get back on its feet without further help from the Fed. But if the recent improvement peters out, the central bank will need to step in again, and with force. It must be ready to do so, and Congress should resolve, if need be, to let it.

(Bloomberg)