For the first quarter of 2014, the economy was said to be shrinking by an annualized 1 percent, a pretty bad result. Now the revisions to that estimate are in, and they are much, much worse. According to the Bureau of Economic Analysis, real GDP shrank by 2.9 percent on an annual basis in the first quarter of this year, the worst such number since the first quarter of 2009, during the depths of the Great Recession.
My colleague John Aziz argues that this alone shouldn't convince the Federal Reserve to halt its tapering of unconventional monetary stimulus, but I disagree. This is a great opportunity to shock the Federal Reserve Board out of its cautious stance, and take some bold action to extricate itself and the economy from a sandpit of pitiful growth and zero interest rates.
Let's review: since late 2008, when it pushed short-term interest rates all the way to zero, the Fed has been completely out of normal monetary policy firepower. Thus, they've tried three rounds of unconventional monetary stimulus, or quantitative easing (QE). The first two rounds of QE were discrete amounts of asset purchases, while the third was open-ended, with a fresh amount of stimulus following every month.
But since late last year, the Fed has been "tapering," i.e. slowly ending, its open-ended program. In the context of six years of mass unemployment, an economy that is well below capacity, and an output gap that might be trillions deep, a sharply negative quarter of GDP is strong evidence that the taper was way too premature. This report might just be bad enough to shock them into reversing course. As I argued a few months ago:
For reasons that remain somewhat obscure, the Fed as an institution is clearly just incredibly uncomfortable with unconventional stimulus, and they've been itching and fidgeting and sweating to cut back on quantitative easing as soon as they can. Ironically, this probably backfires, as their obvious eagerness to cut the program erodes its effectiveness by convincing markets that the Fed intends to tighten policy prematurely, which weakens the economy and forces the Fed to keep up their halfhearted stimulus longer to avoid deflation or another recession. I'd bet that this happens again in the next few months. [The Washington Post]
By my count this is the third time that the Fed has been eagerly trying to extract itself from its unconventional posture, only to have the economy stumble and (probably) force them back into it.
Why this is happening is a matter of some dispute. Some argue quite convincingly that it's because economic elites simply believe keeping inflation at or below 2 percent is by far the most important thing in the world, and neither the Fed nor anybody else with power cares that much about unemployment or trillions in lost wealth.
That argument has to be at least partially correct, in my view. But I suspect the Fed's current quagmire is also partly the outcome of the current balance of ideology and political pressure there, which means that it's also possible that Fed board members are making errors of reasoning and might be convinced to change their views. (Hey, it happened to the once-hawkish head of the Minneapolis Fed, Naryana Kocherlakota.)
For example, some at the Fed have argued that these unconventional stimulus programs are risking financial instability (like Jeremy Stein, though he has since resigned), concluding that the programs should be stopped. But if we accept the increasingly plausible view that without this stimulus, the economy would immediately crash, this suggests that even for hawks who are deeply uncomfortable with unconventional stimulus, the quickest way to get the Fed to stop doing it is to stimulate so aggressively that interest rates can be gotten off the zero lower bound. As Ryan Avent argued two years ago:
One wants to scream, try overshooting for once. Try overshooting for once! Try it! Try pushing inflation up above 2 percent for a while and see if you can't generate enough growth to soak up some slack in the economy, thereby greatly reducing the risk that any little headwind that comes along knocks the economy back below stall speed. Try it! There is no way that a year of 3 percent inflation is bad enough to justify this pitiful hiccuping recovery. Try overshooting! [The Economist]
If the actual explanation for the Fed's behavior is a monomaniacal concern for inflation above all things, then we're basically screwed. But if hawkish Fed elites are actually prolonging their own agony, they might be convinced to change their mind. The worst quarter of GDP in five years is an opportune time to do it.