Fed Strategies May Shift as Economy Shows Signs of Recovery
Economic output contracted at a rapid pace late last year and early this year. Real gross domestic product (GDP) in the U.S. fell at an average annual rate of 6% during the final quarter of 2008 and the initial quarter of this year, the sharpest two-quarter reversal in more than 50 years. Unprecedented monetary and fiscal policy responses helped prevent the widely touted doomsday scenario from materializing, and a 1930s-type debacle has been avoided. Even so, the current episode can be fairly labeled the “Great Recession,” and the world will breathe a deep sigh of relief when it finally moves behind us. 

The Federal Reserve has been a dominant force in the battle against financial chaos and the threat of depression, with Chairman Ben Bernanke repeatedly assuring  markets that the Fed “will not stand down” until these battles have been won. In the process, the Fed has pushed conventional monetary policy to the limit, driving the federal funds rate essentially to zero and publicly committing to maintain that position for an extended period. The Fed also has developed a wide range of policy innovations, including unconventional measures that employ the unlimited power of its balance sheet to maintain credit flows in sectors of the economy that need it the most—including the agency-related home mortgage market and the private asset-backed securities markets for consumer loans and commercial mortgage-backed securities.

Early signals of near-term economic stabilization have provoked speculation about a shift in Fed strategy—from an all-out war against financial market dislocations and economic weakness to a systematic march back toward monetary neutrality. Indeed, futures markets are signaling expectations of a higher federal funds rate by late this year, but the early stages of economic recovery are likely to be quite tenuous. NAHB therefore does not expect the Fed to raise the funds rate until the unemployment rate is on a clear downward path, which may not be before the end of next year. There’s also speculation that the Fed will have to rein in its balance sheet activities because of the inflationary consequences of its asset purchases and corresponding increases in the monetary base. But so far, these increases have flowed into excess reserve positions of commercial banks, with no immediate inflationary consequences. [ return to top ]