What's the Fed to do?

Even though Wall Street has suddenly decided that American companies are worth 15% more than they were worth at about 2:00p.m. est on Friday. I still don't think that anyone has any clue what's going on with the American and global economy. Last week was mostly bad news all around. This is a short week here in the States and I expect it to be quiet.

But of interest is a continuation of what I touched on Friday... what is the Fed to do?

Right before Halloween, the Fed set the target rate for federal funds at 1%. But the reality is much lower than that: the effective rate according to the Economist is 0.25% (it is now about 0.50%):

The irony is that, were the gap to disappear, there would be a de facto tightening of monetary policy. On the other hand, if the effective rate remains near zero, the Fed will have to turn to more unconventional means of stimulating growth. Michael Feroli of JPMorgan Chase proposes outright purchases of mortgage-backed securities—another faint echo of Japan.

So what are unconventional means?

I'm not sure, but one suggestion: Don't do what Japan has done since the 1990s.

And suddendly things look bad again...

The stock market is down, unemployment is up, consumer spending is down, banks aren't loaning money to anyone... that's right the economy still looks bad. And while we might have dodge a total collapse of the credit markets, the key word is "might". A week ago I think most people would have assumed that we/the world had done so. Now? Not so much.

And on top of all this the truly scary word of deflation has begun to be uttered after the announcement this week that consumer prices had fallen 1% in October.

Deflation is, simply, a continuous fall in the general price level of goods and services. This sounds like a great thing—prices go down meaning you and I can buy more stuff. But that's in the very short term. If firms are making less from their goods or services, that means they have to cut back on costs—that can mean anything from cutting jobs, wages, or closing factories. And therefore you and I will be making less, and thus not spending more.

The other worrisome aspect of deflation is that firms and consumers may decide to wait to build/expand their business or wait to purchase goods. If prices are falling, I may wait to buy a new TV or car knowing that in 9 months it will cost less. A firm may wait to build a new factory because the price of the material goods and labor will be less in six months than it is today. What this means is that people aren't spending money and therefore demand continues to fall.

From a policy perspective there is only so much a government can do. Interest rates can only be cut so low—zero percent obviously. The Fed has set interest rates at about 1%. So it can't cut rates too much more (and more on that later).

Krugman and some others have begun to call for a huge stimulus. This makes sense since it would inject billions into the U.S. economy (if Americans are good at anything, it's spending money). While this might be problematic—people might just save that money, pay off debt, or invest it in some market—it also may fix the problem at hand if people spend the money.

But again, policy makers can only do so much in a deflation cycle or period. However, we are seeing policy makers acting quickly and doing something, and as I've aruged, something is better than nothing. Why? Becuase the last time we did nothing, the Depression went from bad to Great. Japan did nothing and it's stuck in 1991. Sweden did something at it is still one of the strongest economies in the world. So although you and your neighbor and some talking heads on TV might not like, sitting on our hands has proven to be the wrong decision.