Monday, October 18, 2010

Will the Fed adopt new target for inflation?

Business Times - 19 Oct 2010

Will the Fed adopt new target for inflation?

Another round of QE is likely, but selling it to the US public may not be easy


A YEAR after the 9-11 terrorist attacks and as economists were warning of the threat of deflation, Ben Bernanke, then a Fed governor, delivered a speech, 'Deflation: Making Sure It Doesn't Happen Here', in which he proposed that the US government can always avoid deflation and its effects of 'recession, rising unemployment and financial stress' by cutting interest rates to zero and by printing more dollars.

'The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost,' Mr Bernanke said.

And referring to a statement made by Milton Friedman, the Nobel Prize-winning economist, about using a helicopter drop of money to combat deflation, Mr Bernanke discussed 'money-financed tax cut', which he explained was 'essentially equivalent to Milton Friedman's famous 'helicopter drop' of money'.

Deflation is a reflection of an insufficient supply of money. Injecting more money into the system should therefore fix the problem.

'People know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation,' Mr Bernanke added. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending.

Those comments earned Mr Bernanke the nickname 'Helicopter Ben', with critics suggesting that his approach runs contrary to the principles of 'sound money', especially during times when the government accumulates debt.

Instead of creating incentives for balancing the budget, charge the critics, Helicopter Ben seems to be more inclined to turn on the monetary spigot and encourage spending, while igniting inflationary pressures and debasing the value of the US dollar - not to mention the negative effects on the ballooning deficits.

In fact, since 2008, Mr Bernanke has presided over a massive effort in putting (not his) money where his (anti-deflation) mouth is - pursuing an aggressive policy of 'quantitative easing' (QE), by buying Treasury bonds with the money created by the electronic equivalent of the printing press, and adding more than US$1.2 trillion to the monetary base.

And guess what? The end result has been a shrinking money supply, a slower than expected economic recovery, and a continuing high unemployment rate.

Fed officials have defended their policy by noting that contrary to what happened during earlier recessions that were caused by the efforts of the central bank to control inflation by raising interest rates - and which the Fed helped cure by lowering rates - the sources and magnitude of the Great Recession are different.

And with interest rates close to zero, the Fed is constrained in its ability to use that tool in promoting recovery and needs to resort to QE as an instrument that could in theory stimulate the economy.

But doubts persist on whether the QE policy has been effective and about its potential dangerous side effects (inflation), concerns shared by some of Mr Bernanke's colleagues in the Fed who have been sceptical about his plans to launch another round of QE, or QE2.

So it was not surprising that officials in Washington (and other world capitals) and investors on Wall Street (and other financial markets) were holding their breath as they waited for Mr Bernanke's speech at the Boston Federal Reserve Bank conference on Friday in which the Fed chairman was supposed to provide some initial details about the QE2 which would be discussed during the meeting of the Federal Open Market Committee (FOMC) on Nov 2-3.

Some reports have suggested that Mr Bernanke would propose expanding the Fed's balance sheet by purchasing between US$500 billion and US$1 trillion in bonds to stimulate the US economy.

Mr Bernanke explained that low inflation and high unemployment made 'a case for further action' by the FOMC when it meets next month. 'Inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve's dual mandate,' he said.

But noting that 'the risk of deflation is higher than desirable' and that 'unemployment is clearly too high' and would probably 'persist for some time', Mr Bernanke seemed to suggest that the Fed's policy committee would need to take some action.

He may have disappointed those Milton Friedman buffs who had hoped to see the landing of Helicopter Ben, falling short in his comments of committing the Fed to a new round of QE.

He seemed to be suggesting that the FOMC would be considering a QE2 - but that it would do that with a lot of caution.

'Possible costs must be weighed against the potential benefits of non-conventional policies,' he stressed, pointing out that 'we have much less experience in judging the economic effects' of QE.

Hence he refrained from discussing the details about the size and duration of a possible QE, suggesting that the lack of experience in judging the economic effects of QE made it 'challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public'.

These factors, therefore, made it necessary 'that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities', he said.

And he admitted that there were legitimate concerns that 'substantial further expansion of the balance sheet could reduce public confidence in the Fed's ability to execute a smooth exit from its accommodative policies at the appropriate time', leading to 'an undesired increase in inflation expectations to a level above the Committee's inflation objective'.

In short, Mr Bernanke was creating expectations for some sort of QE that would be embraced by the FOMC next month. But he and his colleagues have yet to agree on the details of the plan, and no less significant, on the way that the plan will be sold to the US public without raising fears of inflation, perhaps by adopting a new target for inflation.

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