The markets’ reaction to the Federal Reserve’s latest policy announcement isn’t what Chairman Ben S. Bernanke wanted: Long-term interest rates have gone up. That’s a problem because the recovery is still tepid.
The message the markets received isn’t the one Bernanke thought he was sending. What went wrong? Part of the answer is that investors are confused -- and I can’t say I blame them.
In his June 19 news conference, Bernanke said the pace of new asset purchases by the central bank would depend on results. If the recovery slows, quantitative easing will continue for longer or even be increased. He also said, yet again, that any QE is still new stimulus -- akin, that is, to further cuts in interest rates. (As long as the Fed’s balance sheet is growing, the central bank is easing.)
Instead of hearing what Bernanke said about conditionality, investors have focused on the timetable he set out if all goes to plan: The calendar, not facts about the economy, is now guiding policy! Instead of hearing what he said about maintaining the Fed’s enlarged balance sheet, they judged limited expansion against the imaginary alternative of extending QE indefinitely: The Fed just tightened!
You can’t really fault the markets; at least one member of the Federal Open Market Committee reached the same conclusions. James Bullard, president of the Federal Reserve Bank of St. Louis, says the central bank is prioritizing an arbitrary timetable over facts and has deliberately tightened policy -- interpretations that Bernanke had expressly denied.
That’s a shame. Debate on the FOMC is well and good, but it surely isn’t asking too much to demand that the committee express one view about whether it has tightened policy. However, a more important question arises: whether the policy, sympathetically construed (further easing for the time being, cautious tapering of QE as conditions allow), makes sense. I touched on this last week.
Many of the Fed’s critics argue that QE has already gone too far, at the risk of creating high inflation and future financial instability. Others argue the opposite -- that QE should be stepped up to push the economy toward faster growth. This second group is alarmed by the recent decline in inflation and thinks the Fed should have eased policy forcefully in response.
Bernanke is trying to strike a balance, an approach that true believers in both camps find intolerable. I’d say he’s basically right.
He’s discounting the hyperinflation fears of the most agitated QE skeptics, arguing that the Fed can reverse its monetary stimulus when necessary. That’s correct. On the other hand, he accepts that more QE risks future instability. That’s also correct. Persistently low long-term interest rates -- which QE is meant to provide -- encourage investors to take on too much risk and “reach for yield.” That could spell trouble when the policy eventually unwinds.
Even so, doesn’t falling inflation -- the forecast for the Fed’s preferred measure now stands at 1.2 percent to 1.3 percent for 2013, well below the bank’s 2 percent target -- demand more aggressive easing? It does if it fails to turn around. But Bernanke doesn’t disagree. He’s floated that possibility and says he’ll act if he sees a greater risk of deflation.
Not good enough, according to some. At the moderate end, you have economists such as Bullard who think Fed statements should emphasize its readiness to stick with QE if inflation stays too low. At the bolder end, you have those who argue -- in Paul Krugman’s memorable phrase -- that the Fed should “credibly promise to be irresponsible” and increase monetary stimulus until expected inflation rises above the target. That would reduce real interest rates and provide a much more powerful boost to demand.
Though Bullard’s comments about tightening were wrong, I agree that Bernanke should have talked more about the risk of deflation and stressed the Fed’s determination to prevent it. He could have done that without changing anything else he said. However, aiming to create expectations of above-target inflation goes way beyond this and would be far riskier.
Modern macroeconomists stress the centrality of expectations in monetary policy. If the central bank says something and is believed, the economy tends to fall into line. If the Fed promises to do whatever it takes to boost demand and is believed, demand will rise without the Fed having to do much else. That’s the crux of the case for promising boldness in fighting recessions. Promise to be bold, and you won’t have to be. Promise to be timid, and you’ll end up having to be bold.
The logic is unassailable -- but one should always treat unassailable logic with caution. The difficulty is that central banks can’t set expectations just by issuing statements or setting targets (for inflation, for nominal gross domestic product or for anything else). Establishing credibility isn’t easy. After the inflationary excesses of the 1970s, it took years of high unemployment for central banks to prove they meant business. It was hard to suppress inflation expectations and tie them down firmly.
Aiming for higher-than-target inflation now would speed the recovery. If the economy stalls, it’s an option that should be considered, as Bloomberg View’s editors have argued. But it’s a grave error to imagine that this is a low-risk policy. Expectations can’t be guided easily to where the Fed would like them to be. Just reflect on the past few days: There are almost as many interpretations of the Fed’s intentions as there are analysts. A different policy target and a more single-minded FOMC could mitigate that problem but won’t ever solve it.
There is an all-or-nothing aspect to the Fed’s challenge. The central bank would probably have to cause high inflation to loosen the anchor it’s worked so hard to put down. There’d be a burst of growth, but a recession might then be needed to put the anchor back down -- and that’s to say nothing of the heightened risk of financial instability caused by investors “reaching for yield” in the meantime. To judge the cost of this policy, you first have to see that expectations are disobedient, then look beyond the recovery to the next slowdown.
Don’t believe anybody who tells you that central banking in these circumstances is easy, or that the safest policy is the one that looks reckless. Bernanke understands the risks -- of too little action and of too much -- a lot better than his critics do.
(Clive Crook is a Bloomberg View columnist.)
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