Dazed and Confused: The Fed’s Clouded Vision Of The Future

If you are looking for guidance and clarity from the Federal Reserve, your trust will be misplaced. The recently released minutes of the Federal Reserve Open Market Committee's (FOMC) November meeting reveal a deeply divided Fed with no clear consensus on the effectiveness of their policies.
Their review of recent (publicly available) data and their assessment of the current state of the economy reveals their concern and frustration with their inability to effect the course of the economy. Their current projections are:

... Fed policy makers projected a fourth- quarter 2011 unemployment rate of 8.9 percent to 9.1 percent, compared with 8.3 percent to 8.7 percent in their previous forecast in June [2011]. For 2012, the jobless rate will be 7.7 percent to 8.2 percent, up from prior projections of 7.1 percent to 7.5 percent. The rate was 9.6 percent in October, marking 18 months at 9.4 percent or higher.

Officials said the economy will expand by 3 percent to 3.6 percent next year, down from [their] 3.5 percent to 4.2 percent projection in June [2010]; the 2012 forecasts of 3.6 percent to 4.5 percent growth compare with the prior projections of 3.5 percent to 4.5 percent. ...

Policy makers left forecasts for inflation, excluding food and energy, little changed for the next two years, indicating price increases may lag behind the long-run projection of 1.6 percent to 2 percent for at least two years.

Fed officials gave their first forecasts for 2013, projecting growth of 3.5 percent to 4.6 percent, a fourth- quarter jobless rate of 6.9 percent to 7.4 percent and core inflation of 1.1 percent to 2 percent.

Their discussion of policy solutions were all over the board, although "most" of the members supported their quantitative easing policy (QE2):

Most participants judged that a program of purchasing additional longer-term securities would put downward pressure on longer-term interest rates and boost asset prices; some observed that it could also lead to a reduction in the foreign exchange value of the dollar. Most expected these changes in financial conditions to help promote a somewhat stronger recovery in output and employment while also helping return inflation, over time, to levels consistent with the Committee's mandate. In addition, several participants argued that the stimulus provided by additional securities purchases would help protect against further disinflation and the small probability that the U.S. economy could fall into persistent deflation--an outcome that they thought would be very costly.

The lone nay vote on affirming their policy was Federal Reserve Bank of Kansas City President Thomas Hoenig:

Mr. Hoenig dissented because he judged that additional accommodation would do little to accelerate the economy's continuing, gradual recovery. In his assessment, the risks of additional purchases of Treasury securities outweighed the benefits. Mr. Hoenig believed that additional purchases would risk a further misallocation of resources and future financial imbalances that could destabilize the economy. He also saw a potential for additional purchases to undermine the Federal Reserve's independence and cause long-term inflation expectations to rise.

Mr. Hoenig is correct.
They agreed to expand their balance sheet up to $2.6 trillion by March, 2011. They will target maturities in the 2 to 10 range. They also discussed the possibility of purchasing "longer-term Treasury securities." According to the Wall Street Journal article:

In the 1940s and 1950s, the Fed pinned long-term rates below 2.5%. Though the Fed didn't take action in this direction, the discussion suggests the notion could come up later if the economy worsens.

The minutes reveal that is exactly what they plan to do:

The Committee directs the Desk to execute purchases of longer-term Treasury securities by the end of June 2011 in order to increase the total face value of domestic securities held in the System Open Market Account to approximately $2.6 trillion.

This is not additional QE; they are shifting maturity targets in order, in my belief, to "stabilize" long-term rates which, subsequent to their announcement of QE2, have climbed. Also, by extending maturities, they have less pressure to continually roll over their portfolio, as they do with shorter maturities.
Also, as noted by Bloomberg, they discussed adopting what is known as the Taylor Rule, which is to target an inflation level but "decided to retain the policy of giving policy makers’ long-run inflation projections."
I think it is wise to ignore their forecasts and instead focus on what they are doing. What they are doing is monetizing federal debt. They have no idea where their policy of QE is heading and that is because (1) they have been mostly wrong so far, and (2) their internal "vigorous" debate demonstrates that they have serious questions about what they should do.
Inflation is a tricky thing for the Fed because they don't know what it is. They confuse "inflation" with increases in prices, a view held by most economists. And that is one of the main reasons their forecasts have been so wrong and their policies so ineffective. As well, most economists conflate increases in prices with supply and demand factors. For example, the common view is that if oil goes to $150bbl, the CPI will go up. Which is incorrect. It is a simple demonstration of supply and demand: if we have fewer dollars to spend on things other than gasoline then prices on those other things decline.
They do not see that inflation is actually an increase in the supply of money without a corresponding demand for money. Rising prices are one of the impacts of monetary inflation. Other serious effects occur which are even more damaging to the economy than price increases. Some of those impacts are a creation of the boom-bust cycle and the destruction of real capital (wealth created from production, not from money printing).
When the Fed says they wish to create "inflation" through printing money to spur the economy and prevent "deflation" they actually are saying that they wish to trick the citizenry into believing that rising prices are really a result of strong economic activity when it isn't. They believe that wiping out capital, punishing savers, and seeding the ground for a new destructive business cycle is a positive for economic growth.
There is a lot of discussion now about the "psychology" of inflation and how the Fed can make inflation work. Most of it is stuff mainstream economists dream up to explain why their theories don't work. For example, the advantage of "surprise" they had hoped for that would allow them to pump more money into the economy to spur growth without people catching on to what they are doing. I don't really know why mainstream economists say such things, but they do. The psychological anticipation of higher prices is all quite true as price inflation starts taking off. As people anticipate that prices will continue to rise, they will adjust their goals and demand higher returns. Or they will reduce their demand for money and start buying goods that appear to "appreciate." But that "psychology" has to start somewhere and that "somewhere" is with a central bank which likes to print money as the solution to their country's problems. You can't have inflation without it.
I would side with Mr. Hoenig who does understand something about the dangers of inflation. Inflation as a solution hasn't worked here or anywhere and it won't work now.
The markets already sense this. Recall that 30% of the buyers are foreign sovereigns, banks, and investment companies whose countries have rich traditions of destroying their economies through inflation. Perhaps even U.S. based investors understand this lesson as well. The almost instantaneous jump in Treasury rates, especially the long bond, was counterproductive to the Fed's plans to keep interest rates low and make borrowing attractive to businesses. The bond vigilantes know better. So, initially the Fed's QE hopes have somewhat diminished.
When they start discussing a whole new way at looking at how they control money supply (the Taylor Rule) or which maturities they should target in the future, you know they don't have a clue where this is going. The dissension among the members of the FOMC is a rather stark example of why mainstream economics has failed us time and again. Their ordinary tools have failed them and they are desperate, in my opinion, to find something that will work. Thus the wide disparity of opinion between the Fed's anti-deflationists and the anti-inflationists.
I think that they will pump in enough money to create some inflation, even though it may not be that apparent with powerful ongoing deleveraging forces. You can't "helicopter" $2.6 trillion into the economy and have no effect. The result in my view will be stagflation.