Inflation isn’t a concern these days, affording the Federal Reserve elbow room to keep interest rates at, well, virtually zero.
The futures market doesn’t expect the free-money train to end any time soon. Even looking a year out, Fed funds futures are still pricing the central bank’s target rate at under 1%. The FOMC hasn’t done anything to disabuse the crowd from that view. Last month’s official monetary confab press release advised that “the Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent…for an extended period.”

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After Friday’s disappointing update on the labor market in December, the debate about how to boost employment will take on an even greater import, if that’s possible, in the months to come. All the more so as this is a mid-term election year.
Inextricably intertwined in the debate over jobs is the question of when to raise interest rates. The two primary goals: nipping any future inflationary pressures in the bud without derailing the economy’s still-weak capacity for minting new jobs.

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Today’s jobs report for December reminds (as if we needed reminding) that the economic “recovery” will be slow, sluggish and prone to setback from time to time.
Nonfarm payrolls were lighter by 85,000 last month, according to this morning’s monthly employment update from the Department of Labor. That’s a blow for quite a number of economic projections, some of which predicted a small gain. MarketWatch.com, for instance, reported that a poll of economists had predicted a rise of 15000 in the December nonfarm payrolls number.

There is some good news in today’s report: the slight retreat in November jobs that was originally reported (-11,000) was revised upward to a feeble gain of 4,000. Of course, in a labor force of 130 million, such changes are insignificant. Indeed, nothing short of potent growth in the labor market over an extended multi-year period is required to repair the damage from the Great Recession. Even a sustained rise of 300,000 new jobs a month would take more than 2 years simply to return the labor force to its pre-recession high. Unfortunately, almost no one is predicting such a rosy scenario and there’s nothing in today’s numbers to suggest such a positive turn of events any time soon.

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Economist Stefan Karlsson has an interesting critique of Fed Chairman Ben Bernanke’s defense of the central bank’s monetary policy in the 21st century.

The monetary and fiscal stimulus dispensed by governments around the world was arguably effective in containing a recession and staving off depression. But if so, the question becomes: At what price?
Nothing is free in economics and so the world must grapple with the mountain of debt that now weighs on the global economy. In effect, policy makers have traded the acute for the chronic. Was it a worthwhile tradeoff? Perhaps, although the true answer won’t be known for some time, perhaps as long as a generation.
Meanwhile, no one should underestimate the potential risks. A new research paper by professors Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard) bluntly lays out the stakes and the hazards that may be lurking. A working version of “Growth in a Time of Debt,” forthcoming in American Economic Review, makes three key points. Quoting the paper, the authors advise:

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On Sunday, we discussed Fed Chairman Ben Bernanke’s view that monetary policy played no role in the extraordinary bull market in real estate during 2002-2007. The operative quote from his speech: “Monetary policy during that period [2002-2006] — though certainly accommodative — does not appear to have been inappropriate, given the state of the economy and policymakers’ medium-term objectives.”
A number of monetary economists beg to differ. Among the smoking guns: a negative inflation-adjusted Fed funds rate for three years from late-2002 onward.

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December was a mixed bag of performance for the major asset classes, mainly because fixed-income was weak. Foreign developed-market government bonds were particularly hard hit last month, shedding nearly 6%, as the table below shows. But that’s not necessarily a recurring offence, since a fair slice of the loss is due to a strong 4% rally in the U.S. Dollar Index, a rare jump in the buck and its biggest monthly gain since January 2009.

Meanwhile, REITs led in the winners circle for December, rising by nearly 7%. And equities the world over showed handsome gains as well. But thanks to the selling in most of the world’s bond markets, our Global Market Index (a passive mix of all the major asset classes and the benchmark for The Beta Investment Report) slipped a bit in the last month of 2009.

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Fed Chairman Ben Bernanke says the central bank’s monetary policy played no role laying the groundwork for 2008’s financial debacle. The issue here is one of debating if interest rates were too low for too long and if that was a catalyst for sending the real estate market into overdrive.
“Monetary policy during that period [2002-2006] — though certainly accommodative — does not appear to have been inappropriate, given the state of the economy and policymakers’ medium-term objectives,” he said at a speech today in Atlanta at the American Economic Association, CNNMoney reports. The culprit, Bernanke added, was ill-conceived mortgages that made buying homes too easy.
The Fed head is half right. It’s hard to imagine that the real estate boom would have been as strong as it was if interest rates weren’t as low as they were in 2002-2006. Consider our graph below, which shows the effective Fed funds rate less the annual change in inflation, as defined by the consumer price index.

It’s obvious that for a roughly three-year period starting in late-2005, the real Fed funds rate was negative, which is to say that monetary policy was aggressively stimulative. The case for keeping rates low was compelling in the wake of the 2000-2002 stock market correction and the mild 2001 recession. But the central bank misjudged what the economy needed at the time. That’s clear now, with the benefit of hindsight, as a number monetary economists advise.

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Easing the pain in the wake of the Great Recession may be politically if not morally correct. It may even be smart economics, depending on the details and the timing. But 1 +1 still equals 2 and in the end there’s a risk that we’re stimply trading the acute for the chronic. Ideally, finding some middle ground is the goal, but it’s devilishly hard in practice. Meantime, what looks like progress on paper all too often ends up as counterproductive in practice. The best laid plans and all that jazz.
The latest example comes from a report in The New York Times that the government’s efforts at easing the fallout from rising foreclosures in residential housing may be making things worse. The key quote in the article comes Kevin Katari of Watershed Asset Management, a hedge fund in San Francisco:
“The choice we appear to be making is trying to modify our way out of this, which has the effect of lengthening the crisis. We have simply slowed the foreclosure pipeline, with people staying in houses they are ultimately not going to be able to afford anyway.”
We can debate the merits of providing aid to homeowners at risk of losing their homes. We can also discuss the details of how to structure a plan that makes sense in offering financial support. But let’s be honest and recognize that assistance comes with a cost. The price tag may be tolerable, perhaps even negligible. But not always. Sometimes the blowback from helping and intervening can be substantial, even if it’s not immediately obvious today.
There’s still no free lunch, but that doesn’t stop us from thinking (hoping) that it’s different this time.

To all our readers, thank you for your support. Happy New Year! All the best for 2010.