Bernanke’s speech and the politicization of the Fed
Bernanke’s speech has been widely read by people looking for clues on whether QE3, a further monetary stimulus through additional buying of bonds, is coming and I am not going to provide that with this post (there are so many people writing about it that it is possible that every interpretation has already been described). Instead, it’s more interesting to me what Bernanke is saying about those who doubt that the Federal Reserve exit from its current stimulative monetary policy if the economy improved dramatically, labor markets became tighter, which could lead to higher inflation and–more importantly–higher expectations about future inflation.
I don’t actually believe that rising inflation expectations are a likely problem in the next year or two. The main cause of something like this would be a significantly stronger economy than we have now and, well, Mitt Romney doesn’t actually have policies to strengthen it dramatically and Obama does (the American Jobs Act, for one), but the House is likely to be controlled by Republicans for the next 2 years and the Senate will be uncooperative, either because it is narrowly Republican, or because it remains Democratic and Republicans filibuster anything that would help the economy because hurting Obama politically > helping America economically.
But, it is interesting to look at how the Fed would tighten monetary policy while still holding onto the bonds they have been buying, even though the entire discussion about how they will exit hurts the effectiveness of their actions (more on that later). Bernanke said:
A second potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability. It is noteworthy, however, that the expansion of the balance sheet to date has not materially affected inflation expectations, likely in part because of the great emphasis the Federal Reserve has placed on developing tools to ensure that we can normalize monetary policy when appropriate, even if our securities holdings remain large. In particular, the FOMC will be able to put upward pressure on short-term interest rates by raising the interest rate it pays banks for reserves they hold at the Fed. Upward pressure on rates can also be achieved by using reserve-draining tools or by selling securities from the Federal Reserve’s portfolio, thus reversing the effects achieved by LSAPs. The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.
The underlined part is the most important: it is really unnecessary to worry that people are going to stop trusting the Fed to keep inflation under control when the economy recovers. However, Bernanke points out that even if inflation expectations were to rise significantly, the Fed could easily go back to their normal policies for raising interest rates, either by selling a portion of their holdings of bonds or by raising the interest rate paid on the deposits banks hold at the Fed.
One measure of this is the difference between 10-year Treasury bonds and the 10-year Inflation-Protected Treasury bonds (called TIPS), which roughly measure the expected inflation rate over the next 10 years (which would lower the real return on the bonds by the rate of inflation, but not on the TIPS). Here’s that chart; notice the absence of rising inflation expectations.
So, the market agrees with Bernanke that there is not a near-term threat of soaring inflation, and there is still a weak economy, which was why we had the Fed’s stimulus in the past. What do the two things have in common? Paul Krugman summarizes one of the papers presented at Jackson Hole:
“the central bank can still gain traction [for stimulus] if it can convince the public that it will pursue a more inflationary policy than previously expected after the economy recovers. As I wrote way back then, the central bank needs to credibly promise to be irresponsible.
The point is that this is exactly what the Fed has not done. Bernanke has gone to great lengths to reassure politicians that policy will revert to normal as soon as possible, that the Fed remains as vigilant as ever about inflation; and while Woodford doesn’t quite say this, all this amounts to offering forward guidance in exactly the wrong direction.”
What Krugman and Woodford are suggesting is that when Bernanke describes how the Fed plans to curtail rising inflation when inflation expectations are not rising, he may be putting headwinds in place that will curtail the effectiveness of future Fed policy. This is important because, with fiscal stimulus from Congress basically dead in the water, he is not entirely focused on maximizing the effectiveness of Fed policy, in part because the Republicans have spent so much energy criticizing the Fed for sowing the seeds of what they imagine will be hyperinflation, that he has to go out of his way to reassure them that that will not happen. This is politicization of monetary policy, at least in its infancy, and that is not a good thing.
UPDATE: Hey look, the Fed seems to agree about the dangers of the politicization of monetary policy.