The latest gloomy U.S. housing and jobs data, falling auto production and uninspiring forecasts for retail sales and industrial output confirm what most analysts have been saying for months: The world's biggest economy has hit a serious bump on the winding road to recovery.
The more bullish types call this a temporary setback, stemming in part from the Japanese earthquake and ensuing nuclear nightmare, which put a severe crimp in global supply chains. At the same time, high fuel prices have diverted consumer dollars away from the malls. The bearish types acknowledge the special circumstances, but argue that these merely underline how feeble the recovery was to begin with.
Against this clouded backdrop, Federal Reserve chief Ben Bernanke, looking even more subdued than usual, last week reaffirmed the Fed's commitment to keeping interest rates at record lows. "The economy is still producing at levels well below its potential. Consequently, accommodative monetary policies are still needed," he told a banking conference in Atlanta.
This seems sensible. Low rates are supposed to spur borrowing and spending by consumers and corporations; and besides, the Fed doesn't have any other bullets left in its monetary arsenal anyway after two money-printing sprees, known formally as quantitative easing. QE1 may have helped stabilize the tumbling economy and QE2 certainly played a part in the stock market surge last year. But neither got the sputtering economic engine back on the rails.
The rock-bottom rate strategy hasn't worked either. Even with their balance sheets in relatively decent shape, U.S. companies are not exactly rushing to spend money and they are definitely not hiring. U.S. homeowners who were on the edge of ruin haven't been able to use the low rates to dig themselves out of a deep hole. And most other households are still trying to reduce debt, not add more.
If the definition of insanity, in Albert Einstein's famous definition, is doing the same thing repeatedly and expecting a different outcome, there are questions about what the Fed is doing.
"The Fed has become a prisoner of expectations," says Raghuram Rajan, a finance professor at the University of Chicago Booth School of Business and a former chief economist with the International Monetary Fund. "If anything, people expect the Fed to do more magic tricks, pulling rabbits out of its hat, to try and lift the economy out again. The last time, they obliged with QE2. And apart from reassuring the markets that deflation was not a concern … it's not clear to me that QE2 had a great deal of effect."
Prof. Rajan made headlines last year - and famously earned the wrath of fellow academic economist Paul Krugman, the Nobel laureate and prominent New York Times columnist - for publicly calling on Mr. Bernanke to hike interest rates "sooner rather than later."
He hasn't changed his mind, arguing that the costs and unintended consequences both at home and abroad outweigh any perceived advantages.
"We have the sense that low rates are a free lunch, that nobody's hurt and if anything, somebody should be benefiting. But you have to ask yourself: If rates are set lower than where the market would want them set, who's absorbing the cost? Clearly, it is people who are savers. Who are the savers in the economy? Some are firms that have lots of cash sitting on their balance sheets. Some are pensioners. Some are you and me, who have money market funds and are earning close to nothing on them."
Most central banks have recently been diverging from Fed policy and are raising interest rates again, at least modestly, as inflation concerns mount. Yet the Fed shares the blame for that.
Interest rates around the world remained low, even in growing emerging-market economies, partly in response to the U.S. policy of keeping real short-term rates below zero for a sustained period. This underpinned a wave of expansion in countries like China and Brazil and drove up commodity prices, which have come back to pinch the U.S. recovery.
"The benefits of low rates are not huge and obvious," Prof. Rajan says. "If the channels through which interest rates normally work are not working that effectively - if we're not pushing strong investment growth; if we're not pushing strong demand for durable goods by keeping rates low - than we should start thinking more about the cost of those low rates."
People have become so used to dirt-cheap money that the mere possibility of U.S. rates climbing back to, say, 1.5 or 2 per cent (still low by historical standards) makes it seem as if the world as we know it is about to end.
"These low rates seem natural now, because of this fallacy that higher rates are going to be extremely contractionary," says Prof. Rajan, who will present his often provocative views Monday morning at the annual Niagara Institutional Dialogue, a pension conference in Niagara-on-the-Lake, Ont. "My sense is they could well be neutral."