Daredevil Central Bankers

So when they showed up at the Boston Fed conference on monetary policy in sandals talking about bungee jumping, you know that something profoundly different is happening.

For decades, Fed officials and economists have been saying that monetary policy could be governed by a few rules. Plug in a few numbers and you get a good sense about where interest rates should be.

But the Fed already has lowered short-term interest rates to zero and the economy looks like it is sliding back into a ditch.

The grim outlook is causing central bankers to shed their typical conservatism in favor of a new daredevil, “try-anything” approach — asset purchases, giving the blessing to higher rates of inflation for the short-term at least. These were some of the ideas discussed in earnest.

We are about to watch our central bankers wing it like kids at the X Games. One wonders how this is going to go over on Wall Street.

Fed Chairman Ben Bernanke made headlines at the conference by giving another speech preparing the markets for a resumption of the central bank’s purchases of bonds with new money. The goal is to try to bring down long-term interest rates and get liquidity flowing in the economy.

There was plenty of skepticism at the conference about whether it will work. Certainty was in short supply during the two days of talks. Read more on the reaction to Bernanke’s remarks.

Greg Mankiw, a Harvard professor and former top economist for President George W. Bush, summed it up nicely by saying at the start of the conference that macro-economics is in “a state of disarray.”

Any economist that says he or she definitely knows the answer to the current economic ills should be avoided, he added.

Any economist that says he or she knows the answer to the current economic ills should be avoided, one economist suggests.

Only a few years ago, macro-economists were patting themselves on the back, saying that they had achieved an era of “Great Moderation” and that wild swings in economic activity were a thing of the past. This has been replaced by humility and the Great Recession.

With Fed officials casting about for ideas, previously unthinkable ideas were floated. Most jarring to the casual observer is the notion that the Fed accept a higher inflation rate for some period of time.

Other ideas that were mentioned include the possibility of taxing bank reserves or even paper currency; having the Fed target the yield on the 10-year note; or having the Treasury Department issue only bills and no bonds. There also was some wishful thinking that Congress could declare a payroll-tax holiday.

Other economists appealed for calm. Drastically altering policy as a result of the crisis “seems to me to be lacking in logic,” said Bennett McCallum, an economics professor at Carnegie Mellon University.

That’s one ugly forecast

Earlier this year, Bernanke and other Fed officials talked about the economy in terms of a relay race. The economy was growing at a moderate pace fueled by government spending and a buildup in inventories. At some point, there would be a handoff to consumer and business spending. But the economy is no longer running; it seems to crawling around the track.

Fed officials will release an updated economic forecast in mid-November, but their early previews are quite pessimistic.

Bernanke talked about growth picking up in 2011, but only to about a 2.5% annualized rate, which is not enough to make much of a dent in the 9.6% unemployment rate.

Low inflation should also persist, leaving the economy one shock away from deflation.

The Fed cut rates to zero in December 2009. Given this forecast, it is no longer unthinkable to think zero rates could last up to four years.