The Fed’s cost/benefit analysis is incomplete

In analyzing the prospect of doing more, Federal Reserve economists put their possible actions into their econometric models and out comes the costs and benefits. Bernanke basically said on Friday that he’s confident that at least to this point, the benefits of lower rates have outweighed the inflationary costs and the maybe of more action should also lean to more benefit exceeding the cost of higher inflation (there are other costs not mentioned by the Fed like market manipulation and capital misallocation). The problem with this Fed analysis is its all on the short term. There doesn’t seem to be any modeling on their part of the longer term impact of unwinding this infamous balance sheet of theirs at an inevitable point, that may get even bigger, let alone in raising the fed funds rate. After the stock market and credit/housing bubbles that the Fed created, we have now an epic bond bubble that the more the Fed feeds, the messier it will be to unwind. Thus, the eventual unwind must be part of the cost analysis. The deeper the Fed gets with their policy, the more difficult it will be to reverse. Bernanke took credit on Friday for the perceived success of previous Fed actions on the economy and markets but the book on him is not finished until the extraordinary actions they have taken since ’07 has been fully reversed and normalized with interest rates higher. I’m confident that when it happens, the bond bubble pops and this process will be very disruptive and will be a major cost as the monetary policy rubber band has already been stretched to an extraordinary extent.

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