Federal Reserve: Economic shock therapy

Robert Eyler, Ph.D.

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Robert Eyler, Ph.D.

rank Howard Allen Research Fellow and Director of the Executive MBA Program, Claremont McKenna College, Sonoma State University

With the economy teetering on the tightrope of recovery and rumors of a double-dip recession on the rise, it’s hard to tell where the U.S. will land in 2012. Despite efforts by the Federal Reserve to help the world of finance and stimulate growth by dropping interest rates, borrowers are still reluctant to borrow, and banks are still reluctant to lend. The pressure is now on the Fed to provide some relief, but a third round of quantitative easing, or QE3, might not be the answer.

Robert Eyler, Ph.D., Frank Howard Allen Research Fellow and Director of the Executive MBA Program at Sonoma State University, gives his opinion on the likelihood of a recession in 2012 and what the Fed can do — if anything — to shock the U.S. back to life. He says removing problems at the consumer level might be part of the answer. Professor Eyler is the author of “Money and Banking: An International Text.”

Have the odds of a recession in 2012 declined, and if so, what odds would you now put on a recession in 2012?

The odds of a recession have not necessarily declined, but the odds are probably 30 percent for a recession to begin again in 2012. That would depend on geopolitical and unforeseen events affecting global markets and thus acting negatively on the U.S. economy. Three of the main reasons this year was so slow for the American economy were the continued issues in Europe that put into question the U.S. government’s own solvency, the geopolitical issues in the Middle East from January to the death of Qaddafi, and the Japanese earthquake and its effects on the supply chain from Asia to the U.S. In 2010, a year of recovery, these three issues either did not exist or were somewhat muted and priced into markets.

If the Federal Open Market Committee, or FOMC, initiates purchases of mortgage-backed securities or another form of quantitative easing, do the pros outweigh the cons?

The pros outweigh the cons in the sense that the Federal Reserve is doing what it can rather than doing nothing. However, it would be more beneficial for there to be some policy accommodation. For example, Congress could provide more incentives to refinance home mortgages and attempt to remove some of the problems at the consumer level, rather than simply assume the Federal Reserve will cleanse the balance sheets of banks and other lenders yet again. We have monetary policy providing incentives and lawmakers providing disincentives to lend simultaneously, which makes for confusion in lending and also slows down the pace. We need more cohesion, but in general, the Federal Reserve is doing what it can.

Is there anything other than QE3 the Fed can do, or should do, to jump-start the economy?

Not really, and the amount of new debt to be purchased will likely be small in contrast to what has already been done. The Federal Reserve has done about all it can do, and it’s using Operation Twist, which I call QE 2.5 (not quite a third step, but close), to do what it can. The reality is the Federal Reserve cannot solve the microeconomic issues banks and borrowers face, which is really the issue. With prices remaining somewhat slow-moving, labor markets are not showing a lot of strength, which slows both the supply (bank) and demand (borrower) sides of lending markets.

What one single economic issue isn’t getting the attention it should?

If 50 percent of the housing units for sale are either declared short sales or bank-owned properties, it is a great buyer’s market. However, because of the slow supply conditions in banking, we are not matching lenders and borrowers well, which means we have these units on the market longer and longer. It is a chicken/egg problem. Without some movement up in housing prices, banks are less likely to lend due to the continued low equity or negative equity positions of their housing portfolio. However, if they do not lend, those prices have no incentive to rise. In short, if there were a way to reduce the incentives for homeowners to walk away from the risk they initially took, and either spread that risk over time and have banks willing to share that risk, we might see positive change.

We would like to thank Robert Eyler, Ph.D., Frank Howard Allen Research Fellow and Director of the Executive MBA Program at Sonoma State University, for offering his insights. Questions for this interview were contributed by Greg McBride, CFA, senior financial analyst for Bankrate.com.