Paul Krugman Believes Fed Has Space To Exercise Discretion: 'Don't Just Do Something: Sit There'

Nobel laureate and noted economist Paul Krugman's advice ahead of the Federal Reserve's monetary policy announcement on Wednesday is simple — "Don’t just do something: sit there."

Markets heaved a sigh of relief on Monday following UBS Group AG's UBS rescue deal announcement of Credit Suisse Group AG CS as well as the coordinated action by central banks around the world to boost liquidity. The SPDR S&P 500 ETF Trust SPY closed 0.96% higher and the Invesco QQQ Trust Series 1 QQQ gained 0.35%.

All eyes are now trained on the Fed, with many expecting the central bank to pause its rate hike in the backdrop of the banking crisis.

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According to Krugman, the “mess” is a sufficient reason for the central bank to pause until there's more clarity. He pointed out that a lot of funds moved from bank deposits to money market funds that have much stricter liquidity requirements and hence there could be a serious hit to business lending. "Equivalent to [a] significant rate hike," he said.

Inflation Dynamics: Krugman noted that core inflation measures that tried to exclude known transitory or distortionary factors are more pessimistic than labor costs. "Before banks started exploding, we had seen a substantial decline in underlying inflation — but unclear how far we were from target and whether inflation was still falling or moving sideways," the economist explained in a series of tweets.

"Best guess was economy still overheated. But Fed trying to thread a path between Scylla (risk of inflation staying high and maybe even going up) and Charybdis (risk of gratuitous recession) Economy seemed to be barreling along despite rate hikes, but air pockets ahead?" Krugman said.

The economist said he is still worried about the delayed effects of rate hikes on housing employment and incomes.

"But inflation expectations look really well anchored. So the Fed probably has space to exercise some discretion," Krugman said.

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