re: Can anyone defend ZIRP going into 2013?

One of the main problems of ZIRP is that it makes relative risk too high for people to do anything productive with capital. The Fed obviously does not want to add more risk to expansionary investment decisions for people sitting on large capital pools. To the extent that implied volatility metrics may have been caused by Fed statements about easing its inflation targets, this just means that the Fed is more comfortable with inflation. It's certainly not a metric that is signaling an increase in genuine macroeconomic risk, at least not from any common understanding of that term.

Also, I don't think going even deeper in the ZIRP direction is at all consistent with a longer term strategy of gradually introducing risk back into the market little by little. If anything, it just increases the distance the Fed will have to go whenever it finally decides to reverse direction one day in the far distant future. Is the Fed still going to be talking about the fragility of the economy when it's buying Treasury debt while the debt-to-GDP ratio climbs beyond 100%? It seems to be backing itself into just that sort of a corner here.

Thus, ZIRP has corrosive effects not only on individual firm investment decisions, but also on government fiscal decisions, to say nothing about how individual wealth investors may decide to hedge their portfolios by recklessly flooding money into commodities and other asset sectors that often exacerbate positive-feedback scenarios.

All this, however, is tangential to the main point, which is that the Fed should not be doing what it's doing, because it has no legitimate institutional justification for doing so. The economy is not fragile. It may be flat. It may be in poor shape. It may have longer term fiscal disasters already built in that cannot be avoided. It will likely enter recession next year. But none of this implies a fragility that will soon result in a deflationary spiral. Absence such a risk, the Fed should not pursue ZIRP.

So why did I concentrate solely on housing? Because real estate was the source of what caused the financial panic, and once its threat to the system has been worked through (and bank charge-off rates and foreclosure data certainly imply that this is the case), there is no longer a justification for continued emergency measures to prevent slight drops in consumer pricing. Never forget that price stability is what the Fed is all about. So while it is perfectly reasonable to consider fiscal cliffs and equity flows and unemployment slack and all these other phenomena, this only the case so long as they are being considered solely for their potential effects on price stability. If there is no threat to price stability, then the true problem with whatever ails the wider economy lies with fiscal and regulatory policy, and not with monetary policy. To the extent that Ben Bernanke is using monetary policy to hide the non-monetary ill effects occurring in the wider economy, he is doing all of us a great disservice.

It will only increase the pain that will surely blow back in one form or another, and surely, the Fed has been adding more long-term instability to the system than it's been taking away over the past 2 years. To be blunt, bad things are coming, and right now the Fed isn't even trying to counteract them.