I WOULD not have guessed that we'd be replaying last year's script here in 2011, but the similarities to the recovery and policy dynamic this year and last are striking. Last year, early signs of a strong recovery fizzled amid external shocks, and a long waiting game ensued as writers watched for hints of a Fed response while the economy slowly deteriorated. This year, early signs of a strong recovery seem to be fizzling amid external shocks, and writers are beginning to wonder whether the Fed will respond again.

There are a couple of key differences, however. One is that the American recovery is better established this year than it was last year. The labour market, while still very slack, has been improving steadily. The economy has several more quarters of expansion under its belt. And while there is the hint of a negative trend in the economic data, it's not nearly as pronounced as was the case last summer. The Fed tries to avoid reacting to temporary blips, and there are reasons to expect a second-half turnaround.

The other key difference is the inflation environment. While core inflation in America is dormant and long-run inflation expectations actually fell from April to May, a rise in commodity prices pushed up headline inflation figures early in the year, leading some economists to call for tightening. At the New York Fed, Gauti Eggertsson says the Fed won't repeat the mistakes of 1937:

What we call “the Mistake of 1937” was, in broad terms, a decision by the Fed and the administration to implement a series of contractionary policies that choked off the recovery of 1933-37 and brought on the recession of 1937-38, one of the worst on record. What is particularly noteworthy is that the inflation fears that triggered the Mistake of 1937 were largely driven by a rally in commodity prices. These circumstances invite direct comparison with our own time, when a substantial recent rise in commodity prices (which now seems to be abating somewhat) stoked inflation fears and led some commentators to call for an increase in the federal funds rate.



The question for the contemporary reader is this: If we could transport a modern-day economist back to 1937, would he or she have made the same mistake? My suggested answer—admittedly somewhat hopeful—is no. I base this view on the fact that most economists today distinguish between the temporary movements in the consumer price index that stem from volatility in commodity prices and the movements that reflect fundamental inflation pressures. Hence a modern economist most likely would have identified the price rise in 1936 and 1937 as a temporary upswing in commodity prices that did not signal a significant increase in overall inflation.

Well, maybe, maybe not. So what might the Fed do? Jon Hilsenrath recalls Ben Bernanke's statements at his April press conference:

Fed Chairman Ben Bernanke signaled in April that the hurdle to more "quantitative easing," as it is known, is very high and Fed officials have done nothing to indicate that Mr. Bernanke's guidance has changed as economic data has worsened in recent weeks. In an April news conference, Mr. Bernanke said the tradeoffs that would come with additional purchases were becoming unappealing. "It's not clear we can get substantial improvements in [employment] without some additional inflation risk," he said.

Mr Bernanke said at the time that the trade-offs to additional easing are less attractive than they previously were, and so new purchases were unlikely. But he also said that the trade-offs would shift if economic deterioration resumed. And if inflation expectations resume a sustained fall, then the balance of forces may move strongly in favour of additional action.

My sense is that the Fed will do nothing until it becomes more clear that the slowing trend is real. And my guess is that the downward trend will prove temporary, such that the Fed won't need to act. The other thing to remember is that the Fed takes a "stock" approach to easing, which means it is the size of the balance sheet rather than the pace of purchases that matters. So long as the Fed is reinvesting the proceeds from maturing securities its balance sheet isn't shrinking and policy isn't tightening. Of course, "not tightening" may not be good enough. But in my view the Fed has paused. It's watching the data, and the cycle of easing hasn't obviously ended.