Weathering the Frosty Fiscal Forecast


What's this winter's financial forecast? Storm clouds on the horizon with a distinct chill in the air for at least the near term. The Fed's purchase of mortgage-backed securities has made the news, but recession-related headlines continue to stir angst among consumers. What does it all mean?

John A. Tatom, director of research for the Networks Financial Institute of Indiana State University's Scott College of Business, discusses activities of the Federal Open Market Committee, the recession, how the Fed can jump-start the economy and what else needs to happen to improve our fiscal forecast.

If the Federal Open Market Committee initiates purchases of mortgage-backed securities or another form of quantitative easing, do the pros outweigh the cons?

The Fed announced they would purchase up to $400 billion of long-term Treasury securities, which should affect the mortgage-backed securities (MBS) market, as part of their new Operation Twist that began in September. A similar program failed in the 1960s and is so far having trouble getting off the ground. Since it began, almost $50 billion of MBS have matured or otherwise gone off the Fed's balance sheet, and the holdings of long-term Treasuries have risen very little.

But that is OK because the Fed's monetary stimulus has accelerated sharply this year, largely due to asset purchases earlier in the year. This is consistent with the acceleration in growth we have seen since summer and should carry the economy to stronger growth in coming months. There are signs the Fed has been ready for several months to announce another round of quantitative easing, but the market is not giving the Fed any reason to do so. At least over the past year, the Fed has expanded its monetary base by more than 30% and, even net of those funds that were sterilized in excess reserves, the expansion has been more than 10%. This is an extremely large stimulus and, according to incoming data for the last couple of months, probably unnecessary.

Is there anything other than another round of quantitative easing, or QE3, the Fed can do, or should do, to jump-start the economy?

The Fed is in a unique position to get back to its knitting and restore its balance sheet to a more traditional and reputable stance. What I mean here is the Fed could slash the $1.6 trillion buildup of its assets since the crisis three years ago and still provide for more normal noninflationary future growth of its assets by slashing the subsidy it is paying banks to hold a like amount of excess reserves. By selling off its accumulation of long-term securities (not buying more, as currently planned), it could restore the liquidity of its own balance sheet, reduce taxpayer risk, and take a step back to restoring its efficiency, transparency and credibility of policy carried out by using the federal funds rate or a monetary aggregate as its key indicator for conducting and communicating its policies to the marketplace.

As indicated above, right now there have already been unusually substantial efforts by the Fed to jump-start the economy. They appear to be on track to provide strong growth of output and employment. The Fed could use this interlude to restore its ability to provide future stimulus when necessary and to remove some of the market fears that it has pursued a strongly inflationary stance.

Have the odds of a recession in 2012 declined, and if so, what odds would you now put on a recession in 2012?

Yes, after the scare from the slowdown in the first half of 2011 and the debt ceiling extension/federal credit rating downgrade debacle, the risk of a recession this year or next has diminished greatly. There are significant risks emanating from Europe, however, especially due to the sovereign debt crisis there. But even in Europe the risks due to a contagious recession appear to be overstated. The continuing U.S. budget deadlock also poses risks for the financial markets and the overall economy. In 2012, there is a greater risk of another mini-commodity boom, especially for oil, and for an inflation scare than there is of recession, and there is risk the Fed will overdo its effort to rein in monetary growth to a noninflationary pace.

What one single economic issue isn't getting the attention it should?

The current and future federal budget deficits are not getting enough attention. If the supercommittee had succeeded in its plans to reduce the deficit by $1.2 billion to $4 billion over the next 10 years, it would only have been a drop in the bucket compared with the growth in the problem over the past three years. Moreover, given its inability to agree to anything, the supercommittee wasn't able to address the two worst problems for future expansion in the deficit -- Medicare and Social Security. And this "single" issue is multifaceted, extending to all parts of the government. For example, the growing size of the bailouts for the nation's bankrupt housing finance programs at Fannie Mae, Freddie Mac and now the Federal Housing Administration (FHA) compound the deficit problem and threaten financial markets and the economy. Given the link between government housing finance and the foreclosure and financial crises, it is astounding that at least these aspects of the deficit problem have not been fixed.

We would like to thank John A. Tatom, director of research for the Networks Financial Institute of Indiana State University's Scott College of Business, for this interview. Bankrate's Greg McBride, CFA, contributed the questions for the interview.