Fed up

Ben Bernanke is having a tough time. In July, when he presented his semi-annual testimony to Congress, he was heavily criticized for not outlining a plan B. Investors wanted to know what he would do to get the economy moving again if it fell back into recession. So, in August (at Jackson Hole), he duly obliged and explained in some detail the Fed’s policy options. These included: (i) further asset purchases, (ii) committing to keep policy rates low (conditional on economic developments or for a set period of time); and (iii) reducing the interest rate the Fed pays on bank reserves.

This did little to sooth market nervousness. Commentators noted, not only did these options seem a little underwhelming, but Bernanke himself was keen to outline their limitations. Macro Maestro shares this scepticism, but he understands Bernanke’s cautious approach. The Fed Chairman is still clinging to a view of the economy that does not require further stimulus. Perhaps he was hoping data over the next few months would make such a policy discussion redundant, reducing the risk that by outlining these options he further undermines confidence.

Unfortunately, activity data seems likely to remain weak and underlying inflation readings will probably subside further. So it’s important to start to debate about Plan B. There are some, notably in Europe, who are opposed to these policies because they involve taking risks with central bank credibility. There is even a hint of this in Bernanke’s discussion, when he points out that these policies might complicate the Fed’s exit strategy. Macro Maestro doesn’t really share these moral concerns and certainly doesn’t believe they will be a constraint on US policy. (It’s a different story in the euro area.) If the Fed genuinely starts to fear deflation, it will be willing to try anything to avoid it. (Note Bernanke explicitly didn’t rule out raising its inflation target – equivalent to central bank suicide – if the situation deteriorated far enough.)

Macro Maestro’s concern is whether the existing policy options will prove effective. Certainly, there seems little scope to employ Bernanke’s proposals (ii) and (iii). Markets already believe the Fed will keep interest rates on hold for a long time into the future, so there seems little benefit to explicitly saying so. (Especially as they’d probably make this commitment conditional on the economic outlook – the bond market has formed its own view on the economic outlook). And with the interest rate on reserves already at 0.25%, there seems little scope to reduce it further. As Alan Blinder points out, they could make it negative and charge banks for holding reserves but this seems unlikely to provide a powerful impetus for private-sector lending.

That leaves asset purchases. Macro Maestro’s is sceptical about asset purchases because he notes the UK experience. While admittedly we don’t know what would have happened in the absence of Quantitative Easing (QE), even a relatively large asset purchase scheme (purchasing over 20% of the outstanding gilt stock) seems to have done little to boost money supply or private-sector lending in the UK. Asset prices did recover, but only in line with other major economies. That is not to say QE had no effect. Macro Maestro believe the first wave of QE (globally) played an important role in supporting private-sector confidence in early 2009, when many feared monetary policy had already run out of options. But this was largely a confidence trick. If policymakers must resort to another round of asset purchases, Macro Maestro isn’t convinced it will trigger a similar shift in sentiment. And the reaction to Bernanke speech, certainly compared to the reaction this same speech had in 2002, suggests markets have alrady become more sceptical.