The markets’ early reaction to the Federal Reserve’s latest policy announcement isn’t what Chairman Ben S. Bernanke wanted: Long-term interest rates have gone up. That’s a problem because the recovery is still tepid.
The message the markets received isn’t the one Bernanke thought he was sending. What went wrong? Part of the answer is that investors are confused – and I can’t say I blame them.
In his June 19 news conference, Bernanke said the pace of new asset purchases by the central bank would depend on results. If the recovery slows, quantitative easing will continue for longer or even be increased.
Instead of hearing what Bernanke said about conditionality, investors have focused on the timetable he set out if all goes to plan. And instead of hearing what he said about maintaining the Fed’s enlarged balance sheet, they judged limited expansion against the imaginary alternative of extending QE indefinitely.
You can’t really fault the markets. James Bullard, president of the Federal Reserve Bank of St. Louis, reached the same conclusion, saying the central bank is prioritizing an arbitrary timetable over facts and has deliberately tightened policy – interpretations that Bernanke had expressly denied.
However, a more important question arises: whether the policy, sympathetically construed (further easing for the time being, cautious tapering of QE as conditions allow), makes sense.
Many of the Fed’s critics argue that QE already has gone too far, at the risk of creating high inflation and future financial instability. Others argue the opposite – that QE should be stepped up to push the economy toward faster growth.
Bernanke is trying to strike a balance, an approach that true believers in both camps find intolerable. I’d say he’s basically right.
He’s discounting the hyperinflation fears of the most agitated QE skeptics, arguing that the Fed can reverse its monetary stimulus when necessary. That’s correct. On the other hand, he accepts that more QE risks future instability. That’s also correct. Persistently low long-term interest rates – which QE is meant to provide – encourage investors to take on too much risk.
Even so, doesn’t falling inflation – the forecast for the Fed’s preferred measure now stands at 1.2 percent to 1.3 percent for 2013, well below the bank’s 2 percent target – demand more aggressive easing? It does if it fails to turn around. And Bernanke says he’ll act if he sees a greater risk of deflation.
Not good enough, according to some. At the moderate end, you have economists such as Bullard who think Fed statements should emphasize its readiness to stick with QE if inflation stays too low. At the bolder end, you have those who argue that the Fed should increase monetary stimulus until expected inflation rises above the target.
Though Bullard’s comments about tightening were wrong, I agree that Bernanke should have talked more about the risk of deflation and stressed the Fed’s determination to prevent it. However, aiming to create expectations of above-target inflation goes way beyond this and would be far riskier.
Aiming for higher-than-target inflation now would speed the recovery. But it’s a grave error to imagine that this is a low-risk policy. Just reflect on the past few days: There are almost as many interpretations of the Fed’s intentions as there are analysts. A different policy target and a more single-minded FOMC could mitigate that problem but won’t ever solve it.
Don’t believe anybody who tells you that central banking in these circumstances is easy, or that the safest policy is the one that looks reckless. Bernanke understands the risks – of too little action and of too much – a lot better than his critics do. •