US may still need monetary medicine

The IMF's prescription for the US economy could need tweaking, writes Jeremy Warner. In a downbeat assessment of the US economy published last week, the International Monetary Fund said there was "scope for a smaller upfront fiscal adjustment if downside risks materialise". What the directors are saying is that the US can afford to go slow on fiscal consolidation if the economy starts to weaken again. This is the same debate Britain is having about how quickly to cut the deficit. Does it make sense to cut if the economy is weakening? As far as the US is concerned, the IMF seems to agree that it doesn't and has therefore given international blessing to what the Obama administration seems determined, assuming Congress allows, to do anyway - a second fiscal stimulus, or at least a postponement of vague commitments to start squeezing from next year onwards. Advertisement: Story continues below Now I am not saying that the US economy does not need further stimulus. Perhaps it does. Ignore the recent second quarter gross domestic product figures. Growth was much slower than the first quarter at 2.4 per cent, but there were some encouraging signs. Investment was well up, and there was apparently a big surge in new home construction. Yet many of the lead indicators have started to flash red over the past few weeks. The recovery is still highly dependent on public policy support. To withdraw it too soon risks plunging the economy back into recession. On the other hand, there is now evidence that far from being the solution, the deficit is a big part of the problem. As the IMF admits, "setting public debt back on a sustainable path remains a key macro-economic challenge". I would put it more strongly. It is in fact the key economic challenge. The IMF has to be careful what it says about the US, Rosetta Stone Portuguese so there is the customary "welcome" for the administration's commitment to fiscal stabilisation. What fiscal stabilisation? US plans for deficit reduction are vague, and to the extent that they seem to rely substantially on growth to do the donkey work, wholly unconvincing. America risks putting itself in considerable and largely unnecessary long-term peril by continuing to borrow on such a scale. Money and credit are again shrinking fast in the US. The solution is not further fiscal stimulus, which thus far seems to have profited Chinese exports far more than American jobs, but for the Federal Reserve once more to turn on the printing presses through a renewed program of purchases of Treasury securities - in other words, more quantitative easing. The last Fed minutes raised this possibility, and last week there was support for it from James Bullard, the president of the St Louis Federal Reserve and a member of the Fed's rate-setting Open Markets Committee. Mr Bullard said the Fed should be ready to shift its focus to more aggressively pumping credit into the financial system if the recovery appears at risk. "On balance, the US quantitative easing program offers the best tool to avoid such an outcome," he said, adding that his preferred route would be through buying more long-term Treasury securities. In a speech entitled "Seven Faces of The Peril", he says that the Open Market Committee's continued use of "extended period" language was increasing the risks of a Japanese-style deflation. The Fed has for long now said that it intends to keep rates low for an "extended period" but in Mr Bullard's view this might have started to do more harm than good, for it tends to lend support to the idea that the Fed expects things to be bad for a long time, and therefore further damages confidence. A permanently low nominal interest rate environment, a la Japan, would become embedded in popular psychology. Mr Bullard thinks the best solution is continued expansion of the money supply. He must be right, though it is also possible to sympathise with Richard Fisher, of the Dallas Fed, who reckons policymakers have already done enough.