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James Cooper: Easy Fed Money Likely Here to Stay

Thursday, 26 May 2011 08:15 AM

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Don’t expect the Federal Reserve to jack up interest rates soon, no matter what they say about “normalizing policy,” says James C. Cooper, the former senior economist for BusinessWeek magazine, now a contributor to The Fiscal Times, a website funded by the billionaire Peter G. Peterson.

“The timing of any Fed action is becoming increasingly dependent on fiscal policy, especially how the drama over the debt ceiling and the budget battle plays out,” Cooper writes.

“Several possible scenarios suggest outcomes that could keep Fed policy on hold for a long time — perhaps even longer than Wall Street now expects.”

bernanke200.jpg
Fed Chair Ben Bernanke
(Getty Images photo)
The Fed is more likely to try to keep rates down near zero, where they have been since late 2008, for various reasons, including a decline in federal stimulus spending, or “fiscal contraction.”

Cooper outlines three possible scenarios:

Scenario 1: No deal. The Treasury gets to its early August “broke” deadline and runs out of cash with no resolution to the debt ceiling problem. The risk of U.S. default rises and the U.S. economy tanks. “If so, that’s hardly a scenario in which the Fed would want to tighten policy,” Cooper writes.

Scenario 2: A serious effort at deficit reduction, one which combines short-term cuts and long-term entitlement reform. This might be the best path forward, but it would come at a cost: Any short-term spending cuts would slow growth, resulting in the Fed voting to keep rates low, Cooper posits.

Scenario 3: Short-term cuts are made, but politicians ignore entitlements. Investors begin to demand higher yields from Treasurys to compensate for the risk of a U.S. default, which pushes up borrowing costs. Simultaneously, short-term cuts hurt growth immediately. The Fed has no choice but to try to force rates lower.

“Avoiding hard choices is deep in the nature of politics, which increases the chances for this type of compromise. However, it’s a scenario that could put heavy downward pressure on economic growth, which would keep the Federal Reserve on the sidelines for a very long time,” Cooper writes.

Just look at Spain and Italy, and realize that the United States is worse off financially, says former U.S. Comptroller General David Walker, now head of the Comeback America Initiative, also backed by Peterson through his foundation.

“Italy and Spain have a higher rating for fiscal responsibility and sustainability under the new Comeback America index than the U.S.,” he tells CNBC. “The question is, when are the markets going to come after us?”

U.S. debt is now at 100 percent of GDP and growing fast, Walker warns. It will take spending cuts and tax increases to make a dent. "We're not going to grow our way out of this problem," he says.

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