Bernanke’s speech: Clearing the air
Aug 27th 2010, 16:08 by G.I. | WASHINGTON
[Greg Ip] A LITTLE while ago Ben Bernanke, the Federal Reserve chairman, called the economic outlook “unusually uncertain”. The Fed has lately been a source of a lot of that uncertainty. Its officials maintained an upbeat outlook for the economy as the news in recent months went from bad to worse, then on August 10 they seemed to abruptly embrace the opposite view by announcing new steps to stimulate the economy. Matters have not been helped by the public airing of divergent views from officials.
Mr Bernanke cleared up a lot of the confusion with a long speechto the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming today. In a nutshell, Mr Bernanke said the economy has, indeed, underperformed, but it will get better. And if it doesn’t, the Fed will do more unconventional things.
The same morning Mr Bernanke spoke, the Commerce Department was reporting that the economy grew at a miserable 1.6% annual rate in the second quarter, down from its initial estimate of 2.4%. The betting is that the current quarter won’t be much better.
Mr Bernanke admits this is unexpected and disappointing, but it’s not a double dip. The economy will “continue to expand in the second half of this year, albeit at a relatively modest pace [and] the preconditions for a pickup in growth in 2011 appear to remain in place.” Though puzzled that consumption has been so weak, Mr Bernanke notes several developments that bode well for a pickup: the household saving rate was recently revised up to 6% from 4%, suggesting households have made brisk progress in deleveraging, setting the stage for more robust consumption (if only employment and incomes can pick up). Second, financial markets are loosening up, especially since European policy makers got their sovereign debt crisis under control.
Given this constructive view, what to make of the Fed’s decision on August 10 to reinvest the proceeds of maturing mortgage backed securities in its portfolio into Treasury bonds? The Fed had previously bought over $1 trillion of MBS as part of its original programme of quantitative easing to bring down long-term interest rates. The goal of the policy, in part, was to encourage banks and other investors to buy something else more risky, such as corporate loans, thereby boosting investment. But as the economic outlook worsened, mortgage rates plunged, spurring millions of homeowners to pay off their loans and take out lower-rate mortgages. Left alone, this rapid pace of repayments would have led the Fed’s portfolio to contract by some $400 billion by the end of 2011, representing an unplanned but serious tightening of monetary policy. By reinvesting those proceeds into an equivalent amount of Treasury debt, the Fed neither increases or decreases its level of monetary stimulus.
Having explained the past, Mr Bernanke then turned to the future: under what conditions would the Fed do even more? First, if today’s low inflation seems about to turn to deflation. Deflation fears are on the rise, with TIPS bonds forecastinga 10% to 15% probability over the next five years. But Mr Bernanke thinks deflation is pretty unlikely, and in fact doesn’t seem to think inflation will go lower than its current, underlying rate of around 1%.
The second condition, and one more likely to trigger action, is if the economy makes no progress in closing the gaping gap between today’s GDP and potential GDP. As a practical matter, that means growth has to move above 2.5% and unemployment has to drop. Mr Bernanke doesn’t seem to think that will happen until 2011, which implies a willingness to wait a few more months for evidence on the prospects for that 2011 pickup. That the Fed is not ready to do more quantitative easing yet is arguably disappointing. It could easily have justified more action a full year ago given what even then was its lacklustre outlook, and the downside risks (which seem to be coming to fruition). That’s the path the Bank of England, facing similar circumstances, chose. But that’s uncharitable. That Mr Bernanke has not moved as quickly as many of us would have preferred is less important than the fact that his views are still diametrically opposed to the Bank of Japan credo that monetary policy can’t and shouldn’t be used aggressively in a deleveraging, post-crisis economy.
What would additional action consist of? Mr Bernanke cites four possibilities. One, raising the Fed’s inflation objective (now around 2%), he dismissed out of hand: it would “squander” the Fed’s “hard won credibility”. Another, hardening its commitment to zero rates for a long time, would have marginal benefits and run up against the market’s well known tendency to wrongly assume that such commitments are unconditional. A third, lowering the rate the Fed pays on commercial bank reserves at the Fed from its current 0.25%, would have almost no impact on the interest rates that people actually pay.
That leaves buying more bonds. Mr Bernanke points out the benefits of more QE are uncertain and the costs are growing, as the public might worry that the Fed will fail to keep all the money it printed to buy those bonds from producing inflation. Such fears are largely unfounded—the Fed has many more tools for tightening monetary policy than for easing it further. But even unfounded fears can affect reality, for example by boosting long-term rates.
Mr Bernanke made it clear that if either of his two conditions are met, these misgivings would not get in the way:
It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable…Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.
Fed officials gathered under a hail of criticism for communicating badly. The accusations are off base. The Fed doesn’t have a communications problem, it has a policy problem. The recovery has stumbled and the central bank isn’t sure why. Having long ago used up its conventional monetary ammunition, it’s not sure how effective more unconventional ammunition will be. The 17 members of the Federal Open Market Committee, like the outside world, are divided and unsure about what to do. That their divisions have spilled out into the open dismays many at the Fed, but that ultimately doesn’t matter. The Fed is not the Supreme Court. What the chairman wants, the chairman gets. When Mr Bernanke has decided that one of his two conditions will be met, there will be more quantitative easing. Judging from Friday’s speech, he’s not there yet.
The original article is linked here.