We just need some sort of sign
THE Fed's latest policy statement was confusing, even by Fed policy statement standards. The members of the Federal Open Market Committee clearly saw a darkening of the economic picture, likely to produce slower growth and lower inflation than they'd previously expected. And they clearly took action, changing the language of the statement to reflect that the federal funds rate target would most likely be held at the current, low level until 2013. What wasn't so clear, however, was just what the Fed expected that policy change to accomplish. Markets looked it over, thought about it one way and sold off, thought about it another way and bought back in, and then generally went on reading the financial papers, not sure what Bernanke and Co. were aiming for.Given this response, it's safe to say that whatever Mr Bernanke intended the policy to accomplish, its effect was only the mildest of support for the economy. And it's also not surprising that having been left by Mr Bernanke without a clear policy goal or action in mind, markets have gone on responding to bad news by projecting bad economic outcomes. Equities, which had been flat most of the week, dropped sharply today on a raft of bad data. Treasury yields are at record lows. Commodity prices keep dropping.You know, it's hard to be in a position of power at times like these. The stakes are high, and the path forward is uncertain. The thing is, markets are showing the way forward. The deeper the decline in Treasury yields, the clearer it is that markets are scared stiff about the growth outlook. And conveniently, governments can then borrow on incredible terms, using the proceeds to make overdue investments, thereby supporting growth in the short-term and the long-term! The American government can borrow at zero to negative cost at durations out to 10 years. There are always risks, to action and inaction alike, but as risks go, using cheap money to fix deteriorating infrastructure or provide health care to the unemployed or subsidise worker retraining or support research is an incredibly safe bet. In Britain, gilt yields have fallen to their lowest level since the Victorian era. As risks go, slightly easing the pace of fiscal austerity is an incredibly safe bet.What about the Fed, with its too-vague-to-be-effective attempt at additional easing? There's no doubt that many of the members of the FOMC, and especially the dissenters, worry that overaggressive policy could produce runaway inflation. To them I say, have no fear. Markets will warn you when they begin to expect runaway inflation. Just as they're now warning about significant downside risks to growth:Medium-term inflation expectations—the thing the Fed is supposed to be obsessing over—are well below the assumed target of about 2%, and they're falling. After years of this kind of thing, it's difficult to know what more to say. Markets and history alike are indicating the direction in which advanced economies are heading. We can't be completely certain about the nature of the recession and weak recovery, but we can be confident enough to know what general actions are necessary. As Peter Diamond says:[T]he argument about the aggregate demand side is academic, in the negative sense of the word. Current estimates I have seen of how much of the increase in unemployment from a few years ago is “structural,” rather than due to inadequate aggregate demand, still leaves enough need for aggregate demand stimulation that it is clear what direction is needed for further policies.It's hard to imagine that a failure to persuade is the problem. Instead, it seems as though our institutions are the issue; across advanced countries and eras, governments struggle to react appropriately to economic situations like the present. My concern is that we're all destined to repeat the mistakes of history, until by accident or exhaustion of alternatives we stumble upon the right set of policies—which, future historians will lament, were obvious all along. This process probably won't mean the end of the world. But it won't be pretty, either.