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Fed battling economic forces beyond its control

Four years and $1.8 trillion after the worst financial collapse since the 1930s, there appears to be little more the Federal Reserve can do to get the U.S. economy back on track. Rarely in the central bank’s 99-year history has so much been so far beyond its control.

At their regularly scheduled meeting Tuesday, Federal Reserve policymakers made no changes in interest rates and held fire on buying more bonds to pump cash into the financial system. Beyond that, they were expected to devote much time at the meeting to an extensive discussion about changing the way the committee communicates its decision-making with the public.

Fed policymakers have gotten a bit of breathing room lately from data showing a gradual pickup in the U.S. economy. But that growth remains threatened by the financial crisis in Europe, the ongoing budget gridlock in Washington and a housing market that shows no sign of emerging from a deep recession.

After spending close to $2 trillion to put out the financial fires that swept through the U.S. banking system in 2008, Fed officials have watched their European counterparts fail to move decisively as fearful investors flee eurozone countries teetering on the brink of default. Despite calls to backstop Greece, Italy and Spain, the European Central Bank has responded tepidly to the crisis, arguing that those countries need to work harder to balance bloated budgets.

That approach contrasts sharply with the U.S. central bank’s longstanding role as the “lender of last resort.”

“The ECB is making some of the most classic central bank mistakes that history has ever pointed out,” said Kevin Ferry, chief market strategist at Cronus Futures Management. “And they will be criticized again in future history books.”

U.S. central bankers have their own headaches. There is a bloated budget at home and Congress and the White House, locked in an ongoing political paralysis, remain unable to make basic budget decisions. The failure of a so-called supercommittee to arrive at a compromise all but ensured that the budget paralysis will remain until the upcoming presidential election in November.

Ironically, the misperception that the Fed alone can restore economic growth may have made that budget gridlock even worse, according to former Fed governor Frederic Mishkin.

"There’s a tremendous danger from the view that the Fed can solve all problems,” he said. “It actually is a situation where it takes the heat off the politicians to do the right thing. Our problems in this country are not with Federal Reserve or that the Federal Reserve can't solve them. It’s with the damn people in Washington.”

No one can accuse the Fed of not trying hard enough. To reverse the biggest housing market collapse since the 1930s, the Fed embarked on an unprecedented program of buying up hundreds of billions of dollars' worth of mortgage bonds and driving mortgage rates to record lows. Despite that effort, private investors remain leery of putting up cash to back mortgages: roughly nine of our 10 new loans are still backed by the government.

Demand for housing remains sluggish. That’s due, in part, to the estimated 14 million homeowners who owe more on their mortgage than their house is worth.

Those households can’t take advantage of lower rates by refinancing unless they can make up the difference out of pocket or convince their lender to write down their principal balance, which bankers have been loathe to do. (To be sure, some Fed critics have argued that the central bank, as one of the nation’s most prominent bank regulators, could do more to prod bankers to write down mortgages.)

Now, five years after the housing bubble burst, there is a growing realization among homeowners and lenders that it will take years for that critical sector to recovery. After stabilizing this summer, house prices resumed their downward move, falling by 7.5 percent in the third quarter.

Lower rates were also supposed to prod consumers to spend more. But the loss of home equity has taken a big bite out of their spending power. The Fed’s latest data, the so-called Flow of Funds survey, shows that funds continue to leak out of U.S. households in the third quarter as another $2.4 trillion in household net worth evaporated – one of the biggest declines on record. Spending has held up relatively well in the second half of the year, but only because consumers continue to tap what savings they have left.

Businesses are looking for the kind of improvement that would prompt them to hire more workers. But the outlook remains too cloudy for many to move. A survey of small businesses released Tuesday found an uptick in confidence, but it remains at levels usually seen during recessions.

"We still have more firms thinking that business conditions will be worse 12 months from now than better,” said Bill Dunkelberg, chief economist at the National Federation of Independent Business, which conducted the survey. “That can't be the case if we're going to have a growing economy. So they're still very cautious about the future.”

Having already deployed its most powerful tools, Fed watchers expect the central bankers to try to use the language of its statements to amplify the impact of its policies. That could include pegging interest rate moves to economic targets like inflation and unemployment data. By talking publicly about where they see inflation and interest rates headed, Fed officials would hope to have greater influence on the market-based interest rates.

That strategy would contract starkly with the policies of Fed chairman Ben Bernanke’s predecessor, Alan Greenspan, whose convoluted language created a cottage industry of analysts tasked with deciphering “Fedspeak.” That level of obfuscation helped create the impression that the Fed was more powerful that it really is, according to Mishkin.

“One of the real problems of the Greenspan years which was that Greenspan had this element of the guy behind the curtain in the Wizard of Oz,” he said. “People thought that he could do everything. He helped give that impression and, in fact, as we know from the movie, the Wizard of Oz couldn't do very much.”

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