On Bernanke’s testimony

I was on BNN this afternoon talking to presenter Howard Green and The Economist’s Ryan Avent about Fed Chairman Ben Bernanke’s testimony before congress today. You can read Bernanke’s  prepared remarks here and watch the video clip here. Let me say a few words here on how I parse what Bernanke said and what  think it means for the economy.

The Fed Chairman wanted to defend the Fed’s accommodative monetary policy stance by presenting both the logic behind why it makes sense as well as the reasons the Fed would move to a more hawkish position. His goal was to demonstrate that the Fed has the right policy for the US economy and is using the right levers in conducting that policy.

Bernanke said the following right from the start of his comments on monetary policy:

With unemployment well above normal levels and inflation subdued, progress toward the Federal Reserve’s mandated objectives of maximum employment and price stability has required a highly accommodative monetary policy. Under normal circumstances, policy accommodation would be provided through reductions in the FOMC’s target for the federal funds rate–the interest rate on overnight loans between banks. However, as this rate has been close to zero since December 2008, the Federal Reserve has had to use alternative policy tools.

Translation: the Fed must pursue both goals of maximizing unemployment and keeping inflation low. And since unemployment is high, the labor market is sluggish and inflation is low, we need to be accommodative. Normally that means cutting rates. But we have already cut them to zero. Not to worry, we have other tools.

Bernanke then goes into a long description of what those tools are. All of this is boilerplate stuff. Nothing he said is extraordinary. Afterwards, however, Bernanke segues into the part on what would change Fed policy to be less accommodative. And note, the reason for giving both sides of the argument is to signal that the Fed still cares whether its policies create inflation or asset bubbles. Moreover, Bernanke has to do this in order to placate the more hawkish members of the Fed, especially given the recent talk by Fed Governor Jeremy Stein about bubbles that can arise due to easy money.

Bernanke said:

Highly accommodative monetary policy also has several potential costs and risks, which the Committee is monitoring closely. For example, if further expansion of the Federal Reserve’s balance sheet were to undermine public confidence in our ability to exit smoothly from our accommodative policies at the appropriate time, inflation expectations could rise, putting the FOMC’s price-stability objective at risk. However, the Committee remains confident that it has the tools necessary to tighten monetary policy when the time comes to do so. As I noted, inflation is currently subdued, and inflation expectations appear well anchored; neither the FOMC nor private forecasters are projecting the development of significant inflation pressures.

Another potential cost that the Committee takes very seriously is the possibility that very low interest rates, if maintained for a considerable time, could impair financial stability. For example, portfolio managers dissatisfied with low returns may “reach for yield” by taking on more credit risk, duration risk, or leverage.

Etc, etc. Now, many pundits and market watchers are saying that the signs of bubbles are already all around us. And I believe this is true. Moreover, there is no empirical evidence that quantitative easing or the Fed’s zero rate policy has had a positive impact on credit to small businesses, on the real economy, or on jobs. Instead, easy money has pumped up asset prices and re-allocated resources toward higher yielding and higher risk asset classes like leveraged loans.

But what should we expect the Fed to do with its dual mandate? Moreover, Bernanke went further, implying that the Fed is forced to work to counteract the fiscal drag from government.

Although monetary policy is working to promote a more robust recovery, it cannot carry the entire burden of ensuring a speedier return to economic health. The economy’s performance both over the near term and in the longer run will depend importantly on the course of fiscal policy. The challenge for the Congress and the Administration is to put the federal budget on a sustainable long-run path that promotes economic growth and stability without unnecessarily impeding the current recovery.

Notice that Bernanke plays fiscal hawk here even though he is implying that fiscal policy is too tight. I think this is significant because Bernanke has taken this stance repeatedly when questioned about fiscal policy. He starts out saying in effect that the Fed cannot do the heavy lifting alone and it needs fiscal to turn the economy around. Everyone and his sister knows that implies that he wants a fiscal policy that “promotes economic growth”. But then he talks about doing so in a “sustainable” way and goes into a long spiel about fiscal policy and the rise in government debt to GDP.

I believe Bernanke does this for political reasons. He must appear more hawkish than he actually is both on fiscal and on monetary in order to maintain the support of regional Fed Presidents and to forestall all the questions Congress will give him about the Fed’s easy money policies. But Bernanke’s real view is telegraphed at the end when he says “a more rapidly expanding economic pie will ease the difficult choices we face.” Don’t be fooled here. Bernanke is not hawkish on fiscal policy or monetary policy. He wants fiscal policy to be more accommodative so that the Fed can be less so. That will take the heat off of the Fed for supporting full employment and put it where it belongs, on elected members of Congress.

So what does all of this mean?

1. Ben Bernanke needs to present a more hawkish face in public for political reasons. So he does so. In my view, this is important for him to get and maintain on side Fed Presidents like Kocherlakota who used to dissent on the Fed’s easy money policy.
2. Ben Bernanke’s vigorous defense of Fed policy, while expected, certainly reinforces what Bill Gross was saying last week: QE will continue through AT LEAST 2013. Moreover, if you look at the Fed’s own criteria for when it will become more hawkish – 6.5% unemployment and 2.5% inflation, neither of these is achievable until at least the second half of 2014. Translation: the Fed will maintain zero rates through at least mid-2014 and QE through at least the end of 2013.
3. If Congress maintains its pro-cut stance on spending, the Fed will counteract this. Tight fiscal implies easy monetary policy. And while I believe fiscal trumps monetary, I also believe that the Fed is so accommodative now that it has effectively overridden fiscal and then some. Basically, the Fed has erred completely on the side which promotes asset bubbles since monetary policy only works through financial markets and asset prices to be transmitted to the real economy. So by definition, tight fiscal and offsetting loose monetary means asset price inflation and the risk of bubbles.

Overall, in the context of a reasonably sluggish US economy and employment market countered by reduced government fiscal policy support, Bernanke’s testimony suggests the Fed will remain accommodative enough to keep the US economy growing. Until recently, I believed that the combination of fiscal drags and the blow back from Europe would be enough to trigger recession. But the housing market is buoyant, underpinning the household sector’s releveraging and that suggests this recovery can continue, with help from the Fed.