Business Times - 28 Jul 2009
Bernanke: a matter of credibility
With anti-Fed sentiment growing, investors are waiting for Obama to decide if he wants Bernanke to continue at the Fed
By LEON HADAR
FOR more than a year now, the US central bank has been pumping a huge amount of money into the economy - expanding its loans in the form of currency swaps with foreign central banks and directing lending to US banks - in order to get it moving again. And there are some signs that this policy is generating the conditions for an economic recovery.
Indeed, reflecting a bullish moment on Wall Street, better-than-expected corporate results and housing sales propelled stocks last Thursday, left the Dow and S&P 500 at more than eight-month highs and the Nasdaq at a more than nine-month high (although stocks slumped after that on Friday, as unsatisfactory quarterly results from Microsoft, Amazon.com and American Express gave investors a reason to draw back after the Thursday rally).
But notwithstanding the positive impact that the Federal Reserve policies may have had on the economy, there have also been some concerns that this unprecedented flow of liquidity (also known as easy money) could produce a large wave of inflation which could result in rising interest rates which, in turn, could end up cancelling the effect of the recovery from the recession and setting the stage for an even more devastating economic downturn.
Responding to these fears, Fed chairman Ben Bernanke - who has been responsible for the unprecedented loosening of US monetary policy in the last year - sent a clear message to Washington and Wall Street last week, asserting that he had a clear strategy to prevent the American economy from bouncing from the frying pan of the current recession into to the fire of an inflation or even the more hellish stagflation.
In reality, there have been no signs of inflation on the horizon; deflation still remains the main concern. And in fact, the recovering economy has yet to start creating jobs, which should mark the start of real economic health. That explains why Mr Bernanke insisted during his two-day testimony on the health of the US economy on Capitol Hill that the Fed will continue keeping a key bank lending rate at near-zero.
But he also pledged to keep inflation under control if and when the recovery from the recession really, really takes hold (he made similar points in an op-ed published in The Wall Street Journal).
Most economists expect unemployment to increase in 2010 and predict that GDP growth next year will continue to probably be weak. While Mr Bernanke cautioned that unemployment would remain high into 2011, he expressed a sense of optimism about the potential for a gradual recovery of the economy - which could then put pressure on the Fed to reverse course and put the brakes on its loose monetary policy.
'However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can 'be withdrawn in a smooth and timely manner as needed,' Mr Bernanke said in his comments to the House Financial Services Committee.
Hence, he insisted that the Fed will bring to an end the massive monetary stimulus to the economy as soon as it could do that. The fact that the recovery is expected to be gradual would give the Fed more flexibility in terms of timing its action. But timing will be everything.
Indeed, Mr Bernanke (an economics scholar who had done research on the Great Depression of the 1930s) would probably remind us that when president Franklin D Roosevelt decided to tighten monetary policy at the start of the fragile economic recovery he presided over, he ended up pushing the economy back into recession in the late 1930s.
Hence, based on that experience, the lesson for the Fed is not to risk pressing the economy back into recession by acting too soon and raising interest rates before a real economic recovery.
But what if Mr Bernanke decides to act too late? In that case, he could risk igniting a devastating inflation, which remains the nightmare scenario on Wall Street. Indeed, investors are very worried that the White House and Congress would put enormous pressure on the Fed to refrain from raising interest rates before consumers feel the full effects of the economic recovery in the form of a fall in unemployment rates and a rise in housing prices.
While Mr Bernanke did not allude to such political factors that could affect the Fed's policies, he did discuss the technical dilemma that could face the US central bank in terms of deciding when the right time would be to switch the monetary gears. 'Since monetary policy takes time to work, the only way we can do that is by trying to make a forecast,' Mr Bernanke told lawmakers. He explained that policymakers would 'use large amounts of information, including qualitative information, anecdotes we receive, formal models, a whole range of techniques to try to estimate where the economy is likely to be a year, or a year and a half from now.'
But he then warned: 'It's a very uncertain business, but it's really all we can do.'
And the Fed's policymakers would have two main weapons as they try to manage their exit strategy. In addition to targeting the federal funds rate, Mr Bernanke and his colleagues at the central bank are also planning to contain the threat of inflation by applying a new tool that Congress provided it last year, which allows the Fed to raise the interest rate that it pays on reserves deposited at the Fed.
The hope is that banks will choose to keep those reserves on deposit at the Fed, rather than lending them out into the economy. The expectation is that the use of these two policy tools - raising interest rates and paying interest on reserve balances - taken together will reduce the flow of money into the economy and lessen the threat of inflation.
At the end of the day, much of the Fed's success or lack of it in implementing this monetary exit strategy depends on the credibility that Mr Bernanke enjoys on Wall Street and Capitol Hill.
It seems that when it comes to investors at home and abroad, Mr Bernanke continues to enjoy quite a lot of support. According to the recent Quarterly Bloomberg Global Poll, global investors gave him high marks for his performance in combating the current financial crisis and favour his reappointment as Fed chairman.
But the attitude among lawmakers on Capitol Hill is quite different. Here, there is growing criticism of the Fed's performance and rising pressure to reduce the institutional and political independence enjoyed by the US central bank.
A new Federal Reserve Transparency Act, sponsored by libertarian Ron Paul, a Republican from Texas, and social-democrat Bernard Sanders, an independent from Vermont, would subject the Fed's decisions to a comprehensive audit by the Government Accountability Office, the investigative unit of Congress.
The bill has already attracted 276 co-sponsors in the House of Representatives and 17 in the Senate, reflecting the populist anti-Fed sentiments in Washington and around the country.
But if interest rate and credit policy are transformed from decisions made by impartial and cool-headed economic professionals in the Fed into a set of choices reflecting pressure from the public and interest groups and made by politicians in Washington, it would wreck the current faith that the financial markets have in US monetary policy and ensure that every financial crisis would become a catastrophe.
Most investors do not expect this anti-Fed legislation to be approved by Congress.
But they are waiting for President Barack Obama, who has praised Mr Bernanke's performance at the central bank, to decide whether he wants him to stay at the Fed for another term or to replace him with another well-regarded economist who would lead the economy towards recovery.
Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.