Don't Take This Recovery for Granted

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The better employment figures are welcome, but the economy remains vulnerable at many points, and especially to another setback in the housing market. Before the expansion is at all secure, macro policy is turning prematurely from expansionary to neutral (monetary policy) and from neutral to contractionary (fiscal policy). As I note in this column for the FT,

Fed officials are divided about the future of quantitative easing - the bond buying programme the central bank adopted as a way to loosen monetary policy once it had pushed short-term interest rates, in effect, to zero. QE2, the existing $600bn phase, was supposed to run till June. The strengthening recovery - modest and tentative though the improvement may be - has caused speculation that the policy will be halted before then; and not many analysts are counting on a QE3 to replace it.

The economy needs a third phase of quantitative easing. Admittedly, there are supply-side pressures on inflation from commodity prices, but core inflation is well suppressed, wages are not rising and inflation expectations remain low. With employment growth still tepid, it would be a mistake to end QE this summer, let alone sooner.

The fiscal outlook clinches the point. The US preoccupation with federal borrowing - as opposed to borrowing by the whole public sector - has obscured the role of fiscal policy. The federal stimulus was mostly absorbed in offsetting the automatic tightening of fiscal policy by individual states, whose borrowing is strictly constrained. The federal stimulus was big but, in the aggregate, fiscal support for the recovery has been modest. Now the federal stimulus is running down and many states are embarking on severe and immediate spending cuts and tax increases.

And if all that were not worrying enough, Congress is piling on the uncertainty by failing to resolve the short-term budget impasse...

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