Monday, March 01, 2010

How long can Bernanke keep up the juggling act?

Business Times - 02 Mar 2010

How long can Bernanke keep up the juggling act?


US FEDERAL Reserve chairman Ben Bernanke's semi-annual report on the state of the American economy last week was comforting. He reassured everyone that the economy was slowly getting better.

But, he added, it would take a long time for unemployment to start edging down and thus the Fed had to keep interest rates low to help keep the economy going for a while longer. Bravely, he also said that the Fed would prepare to exit from this period of loose monetary policy.

Mr Bernanke's comments during the Congressional hearings on Wednesday and Thursday underlined the need for the Fed to juggle its two primary but conflicting mandates - maximising employment and keeping prices stable.

With America's unemployment rate hovering around 9.7 per cent, leaving 14 million people unemployed - nearly half of the unemployed have been out of work for at least six months - Congress and the White House want the central bank to refrain from raising interest rates that could slow-down the economic recovery and threaten any incipient growth in employment.

But while encouraging job growth is clearly the most important priority of politicians in Washington as they prepare for the November Congressional races, the Fed has to consider the economic consequences of job-creating fiscal policies that could make it more difficult for the central bank to achieve its other priority: maintaining price stability. Indeed, even while Mr Bernanke was testifying before the House of Representatives, the Senate passed - in an impressive bipartisan vote of 70 to 28 - a proposed US$15 billion job bill that is aimed at encouraging businesses to hire more workers.

While no one applied the term 'stimulus package' to describe the bill, it does involve another surge in government spending, which, in turn, adds to the expanding federal deficit that could ignite inflationary pressures and threaten price stability.

The federal deficit, which has reached US$1.6 trillion, is currently at 10.6 per cent of GDP. The Obama administration expects it to fall to about 4 per cent of the GDP in the coming years.

Responding to the concern of the lawmakers and the people they represent, Mr Bernanke sounded empathetic when he discussed the job market. 'Of particular concern,' he said, 'is the increasing incidence of long-term unemployment.'

Moreover, notwithstanding the concerns in Washington and Wall Street over the potential inflationary risks produced by the expansive fiscal and monetary policies that have been pursued since the start of the Great Recession, Mr Bernanke seemed to be assuring Congress that the Fed's primary interest rate target, which is supposed to encourage borrowing, spending and investment and which has been near zero since December 2008, would remain low for a long time.

As Mr Bernanke and his colleagues at the Fed see it, there is still too much slack in the US economy and there is also no sign of inflation. Hence, 'economic conditions, including low rates of resource utilisation, subdued inflation trends and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period'. In fact, it will probably be months before the central bank starts raising interest rates.

During his testimony, Mr Bernanke seemed to be making a special effort to calm investors by downplaying any policy implications from recent moves on the discount rate, the closure of the majority of emergency lending facilities, and the gradual phasing out of the Fed's purchases of mortgage-backed securities.

He described these moves as part of 'normalisation' of policy that should be seen as leading to changes in the federal funds interest rates.

'These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve,' Mr Bernanke said.

'These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signalling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC.'

How long he can keep up this juggling act remains to be seen. If interest rates stay at near zero for many more months, demand may pick up and perhaps the jobless rate will start to drop. On the other hand, inflation may start creeping upwards. But then again, nothing may happen and that may indicate that the US may be contracting Japan's economic malaise.

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