The time has come for the Fed to make some difficult choices

To acknowledge that which we do not really know requires clarity, to act despite knowing that we do not know enough requires conviction. The past week\'s data from the US Labour Department has brought predictable reactions from Right and Left leaning analysts of the American economic firmament. From data released for the week ending May 21, the seasonally adjusted initial claims was 424,000 which was 10,000 more than the previous week\'s figures. The ‘initial claims\' is one of the reports issued by the Labour Department which estimates the number of people who have filed for unemployment benefits for the first time. In a sense, this is a proxy for the emerging contours of the unemployment landscape. Predictably, the rise in the number of unemployed is a bit shocking especially given claims of an economic turnaround. Another piece of data that also pointed towards muted growth is the rate of growth of gross domestic product. Usually, the Bureau of Economic Analysis issues an advance estimate; and then once a complete set of data is available they issue a second estimate. This estimate is usually revised upwards, indicating that the conditions have improved more than originally expected. However, this time such revisions weren\'t to be. Between the fourth quarter of 2010 and the first quarter of 2011, the advance estimates for the annualised real GDP growth was 1.8 per cent. Subsequently, when a second estimate was provided this was also 1.8 per cent. This lack of upward revision was, as David Leonhardt of the New York Times reports, \"a real surprise.\" Another widely reported deflating fact was that the growth of the second quarter of 2011 was only 2.8 per cent and not the expected four per cent. All of this points to an economy that is tottering, stumbling and still all too unpredictable. Compared to the historical trend of Real GDP, the current forecasts show a potential output gap of more than $600 billion (Dh2.2 trillion). Since 1947, the aggregate real GDP had an average growth rate of 3.3 per cent. When we look at deviations from the trend we find the maximal positive deviation was 3.43 per cent ie, the economy grew 3.43 per cent more than the average observed historically. Since 2000, however, the growth has been less than the historically observed 3.3 per cent. What is startling however, is the -13.4 per cent deviation from the historical growth trend. Theorists This is where intellectual predispositions emerge and influence policy prescriptions. For Keynesians like Paul Krugman, Mark Thoma and Brad de Long, this nearly 13 per cent decline from historical trend is evidence that government must actively get involved. For those of the more ‘new classical\' persuasion, like Stephen Williamson, this evidence is not enough to justify doing anything unless we know more of what is causing this dramatic slide. The new classical-ists argue this slowdown may have nothing to do with credit or money supply and is perhaps out of the reach of any Government fix. The Keynesians suggest following policy recourses to stem the slowdown such as extending business tax credits, household tax cuts and jobless benefits. As this column had argued more than two months ago, the possibility of a QE3 (quantitative expansion 3) is non-trivial and likely to increase in the months ahead. Neither side is naïve enough to ignore the possibilities that these evidences are being marshalled in the debate on whether the US Federal Reserve must launch a third version of the quantitative easing. So much so that Brad de Long, key voice in the liberal economics firmament has come out with a four-point agenda: Time for Quantitative Easing, time for pulling more spending from the future forward into the present, and pushing more taxes from the present back into the future, time to use Fannie and Freddie to (temporarily) nationalise mortgage finance and fix the ongoing foreclosure crisis, time for a weaker dollar. But many have argued QE3 is unlikely to affect aggregate demand until we get a better sense of what is motivating this slowdown. In many ways, such demands for a detailed exposition are unlikely to come by and an academic luxury. The political economy of unemployment imposes upon the political class the need to do something and more importantly to impress upon the electorate that something is being done. The costs of being perceived as inactive are too high. All of this begs the obvious question, what should the markets expect. One thing is clear that should the unemployment figures rise and growth figures sag we should expect to see greater levels and arguments for government spending, rising governmental debt levels and dollar-weaknesses. The elephant in the room is the issue of Quantitative Easing 3 wherein, loosely, the Fed buys securities in exchange for cash. Evidence of inflationary pressures are on the move (even if inflation figures are at historic lows). The Federal Reserve is increasingly likely to find itself stuck between a rock and a hard spot: between possibly accelerating inflationary expectations and a declining aggregate demand. The time to make some hard choices is increasingly near.