KRUGMAN: The Fed May Have Just Made A Historic Mistake, And Done More Damage Than It Realizes

REUTERS/Jason Reed

The most important story in the world is the change of direction in U.S. interest rates, which coincides with the change in tone out of the Federal Reserve. On Wednesday the Fed indicated that so long as its economic projections come to pass, it plans to slow down on Quantitative Easing later this year, with an eye towards totally ceasing bond purchases sometime in 2014.

The markets puked on the news, and interest rates shot up, a move that was exacerbated by Bernanke himself saying he was not worried about the rise in rates.

According to Paul Krugman, it's possible this will end up as a "historic" mistake.

If the economy recovers, then fine, whatever, the Fed will get away with it.

But let's say things sputter out again, and it becomes clear that more easing is necessary. Sure, the Fed can ramp back up QE, and step on the gas pedal again. And the Fed has indicated that it retains this ability.

The problem though is that by acting like a traditionally responsible central bank (trying to avoid inflation and bubbles pre-emptively) it can no longer commit to being irresponsible, which is what many have argued is necessary to truly avoid a deflation trap. There's a widespread belief that what's needed is for the Fed to somehow signal that even if inflation runs hot, that it won't step off the pedal until the economy is at full potential output again. By acting pre-emptively just when things seem to be OK, the Fed has blown that tool.

Says Krugman:

So what if recovery stalls, and inflation expectations fall even further? Can the Fed turn on a dime, and send a credible message that it really isn’t so conventional-minded, after all? It’s hard to believe; having already shown itself inclined to start snatching away the punch bowl before the party even starts, it has arguably already given away the game.

I know that the latest had overwhelming support on the FOMC; I’m surprised and a bit shocked by that, and worry that we may have seen incestuous amplification at work.

I really hope that the real economy recovers at a pace that makes my fears groundless. But if it doesn’t, I fear that the Fed has just done more damage than it seems to realize.

Check out his whole post here.

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