October 18, 2010
What Can We Expect Next from the Bernanke Fed?
by Roger W. Garrison on October 18, 2010
On October 15, Ben Bernanke spoke at the Boston Fed’s conference, “Monetary Policy in a Low-Inflation Environment.” His remarks were long and ponderous and consisted mostly of “Fedspeak” along with seeming excerpts from a typical intermediate-macroeconomics textbook. He rehashed the Fed’s statutory mandate of maximum employment and price stability — which comes from the Keynes-inspired Full Employment Act of 1946. He explained that the two goals compete for the Fed’s attention, which means that neither goal can be pursued singlemindedly. In the short run, advancing on one front may entail retreating on the other. In the long run, the Fed must be content to focus on the issue of price stability. The long-run level of employment is determined by real forces in the marketplace and not by central-bank policy.
Price stability is defined in a perfunctory way. It means an inflation rate of 2 percent — a figure that supposedly commands a broad consensus and is far enough above zero to keep the Fed’s policy committee fully in play. With a 2 percent inflation rate, which puts a 2 percent inflation premium on interest rates, the FOMC has three options: It can raise interest rates, lower them, or keep them the same. With a 0 percent inflation, the Fed loses one option. The “zero lower bound” on nominal interest rates has long weighed heavily on Bernanke’s mind. Conventional open-market operations, in which short-term government securities are bought with money newly wrenched into existence, cannot push nominal interest rates into the negative range. At the zero rate, the Fed has put itself in the position of a first-time water skier who has the tow rope pulled up against his Adam’s apple.
Ironically, Bernanke argues in favor of deliberately creating a 2 percent inflation rate in order to be able to respond in conventional ways should a recession threaten. There seems to be no recognition that a Fed-engineered inflation and the resulting market distortions, especially the interest-rate distortions, are precisely what cause a recession to threaten. Or that true price stability might entail a pattern of prices, wages, and interest rates brought about by the market in the absence of monetary manipulation by the central bank.
How, though, can Bernanke create an inflation when short-term interest rates are already at or near zero? He is inclined to add longer-term securities onto the Fed’s balance sheet. After recognizing that the Fed doesn’t have much experience with this mode of injecting new money, he goes on to address worries about having the Fed’s balance sheet encumbered with these longer-term — and less liquid — securities. His own worry, though, is strictly a derived worry. That is, while he is confident that he has the tools to execute a smooth exit from this extracurricular monetary easing — presumably involving a ratcheting up of the rate of interest (now 0.25 percent) that the Fed pays banks to hold reserves, he worries that there might be a lack of such confidence in financial markets. The consequent expectations of uncontrollable expectations, even if unwarranted, can be harmful to the economy. The hapless reader of the Bernanke speech will see that we have to count on worries within the Fed about worries outside the Fed as our best hope that we won’t suffer an engineered inflation.
If there is something new in Bernanke’s speech, it’s a pregnant idea in his penultimate paragraph. In recent years, each FOMC meeting is followed up with a summary statement that includes strong clues about what the Fed might do in the future. “Near-zero interest rates are likely to be maintained through the fall of next year.” These sorts of statements are aimed at narrowing the range of expectations that emerge in the financial sector and beyond. Of course, people form their own expectations, and the mean expectation is not necessarily pegged to “the fall of next year.” The whole rational-expectations revolution, which dates from the 1970s, suggests that people’s expectations are not, on average, systematically different from actual outcomes.
“There seems to be no recognition that a Fed- engineered inflation and the resulting market distortions … are precisely what cause a recession to threaten.”
But, of course, “the fall of next year” may turn out to have no relevance to the actual outcome. Obviously frustrated by the ineffectiveness of the typical FOMC statement, Bernanke offers for consideration (it’s his only such offering) a modification of the language in these statements. Forget the fall of next year and indicate instead, “The Committee expects to keep the target for the federal funds rate low for longer than markets expect.” Shouldn’t he have said, “for longer than the Fed expects markets to expect”? In any case, this modification will take the spotlight off the fall of next year. But what will it do beyond that? The image that comes to mind here is that of Holmes and Moriarty in a house of mirrors.
One thing this newest piece of Fedspeak will surely do is to create an intellectual challenge for practitioners of rational-expectations theory. The convolution of expectations may leave them wondering if the two-way feedback may take rationality out of play.
And one thing this newest piece of Fedspeak surely won’t do is give us maximum employment and price stability. Of course, few of us outside the Fed would expect otherwise.