Now for Something Completely Different: WPA

With the US economy stalling in H1 and poor survey data, it is hardly surprising that Bernanke's Jackson Hole speech is anxiously awaited for fresh signals about how the Federal Reserve will respond.

Yet, unlike a year ago, the risk of deflation has all but disappeared. Core CPI is just below 2% and core PCE in Q2 stood at 2.1% (compared with 0.8% in Q3 2010). Not only is the Fed's preferred (but not sole) inflation gauge elevated, the $600 bln of Treasuries the Fed just finished purchasing and continues to hold appears to have done very little in real economic terms or in rekindling the animal spirits of risk taking.

Interest rates are considerably lower than a year ago. With the US 2-year yield within the Fed fund target and the 5-year yield below 1% and the 10-year yield just above 2%, how much lower can yields go? And will a marginal decline in Treasury yields from have much impact? Will a marginal increase in the Fed's balance sheet have much impact?

It is difficult to know what the market is really expecting from Bernanke at the end of the week. Many banks seem to be playing up the odds of QE3 being signaled, but they seem to have a vested interest. There are a number of other options that Fed officials have cited. These include cutting the interest rate on excess reserves (though no one is really talking about a negative rate or a penalty for holding excess reserves), extending the maturities of the Treasuries the Fed holds, and including the size of its balance sheet in guidance about rates remaining low for an extended period of time. At times, the idea of a formal inflation target or a interest rate target for yields further out on the curve have also been suggested.

While Bernanke will want to show that the Fed still has options at its disposal, with various trade-offs associated, perhaps he may want to also underscore the limitations of monetary policy.

With nominal and real interest rates extremely low, banks with ample wherewithal to lend, and easing loan conditions (as reflected in the most recent senior loan officer survey) maybe at this juncture there is not much more that monetary policy could do.

If current conditions are somewhat like the Great Depression, then we may need to face up to the fact that it ultimately was not monetary policy that ended the crisis but fiscal policy. A couple of weeks ago, the Spanish Finance Minister was quoted saying that it was more important for Spain to reach its austerity targets than revive growth. This is seems, well, foreign, to many Americans. It is not that growth is panacea, but it does make seem to make problems easier to deal with.

In the US, despite the hand wringing over the debt ceiling debate and recognition that the fiscal trajectory is not sustainable, polls suggest jobs are more salient to Americans than immediate deficit/debt reduction.

One of the largest and, arguably, among the more successful New Deal efforts was the 1935 Work Programs Administration (WPA--later the Work Projects Administration). It worked with local and state governments that covered 10-30% of the cost of the program that hired millions of workers that performed a wide range of functions including the construction of buildings and roads.

In 1935, the Federal government spent $1.4 bln, which was 6.7% of that year's GDP. Over the course of the WPA some $13.5 bln was spent and at its peak 3 mln men and women were employed. Between 1935 and the end of the program in 1943, some., the WPA created some 8 mln jobs. It impacted almost every community.

The press reports that Obama is preparing a major speech next month and will unveil new economic initiative. A WPA program dovetails nicely with calls for an infrastructure bank. Such an effort, especially if coupled with a medium terms strategy to address the excessive public debt, could make good for good politics as well as economics.

As a student of the Great Depression, especially through the monetary lens of Milton Friedman, Bernanke has argued that the Federal Reserve exacerbated a "normal" business cycle and turned it into a monumental crisis. Now at the helm of the Fed, he has succeeded in turning back the threat of deflation. Perhaps the necessary heavy lifting cannot be done through monetary policy. Perhaps now is time for Bernanke, who helped devise a virtual alphabet soup of facilities to ease the credit crunch during the crisis, to remember one more: IMF--It is Mostly Fiscal.