With U.S. Federal Reserve Board chairman Ben Bernanke set to deliver his annual address at the Kansas City Fed’s economics symposium on Friday, investors are placing bets on whether he will unveil a major new round of monetary stimulus.
But others are asking a more important question: Why bother?
Financial markets have gyrated all week amid a feverish debate about the prospects of the Fed launching a new program of so-called quantitative easing, in the form of buying bonds to keep rates low. Those hopes were fading quickly late in the week, as Wall Street and academic economists dismissed the possibility, for different reasons.
One school of thought is that the Fed, having already slashed rates effectively to zero, has already done about all it can do on the stimulus front.
“It’s hard for me to see that the Fed has many options at this point that would be very effective,” Daniel McFadden, the University of California at Berkeley professor who shared the Nobel Prize in 2000, said in an interview at the latest Meeting on Economic Sciences, a gathering of Nobel laureates and young economists in Lindau, Germany. “They have a few tools, but whether they have enough tools to get the banks anxious to place [lend]their funds is doubtful to me.”
With the U.S. unemployment rate at 9.1 per cent and other indicators signalling that the recovery lost considerable momentum in the first half of the year, there is a case for a policy response. But there’s another problem facing the Fed. The underlying inflation rate remains uncomfortably close to the central bank’s unofficial target of about 2 per cent, meaning policy makers may find their hands tied until price pressures ease.
On the eve of Mr. Bernanke’s address in Jackson Hole, Wyo., analysts were warning clients that the U.S. central bank chief was sure to disappoint anyone who still expected the speech to herald a third multibillion-dollar round of asset purchases.
“The focus is entirely on Ben Bernanke,” Jimmy Jean, an economist at Montreal-based Desjardins Capital Markets, said in his daily note on Thursday. “Market sentiment has been improving this week based on anticipations for a surprise tomorrow. Those anticipations may prove naive for now.”
The reality of Mr. Bernanke’s dilemma is likely to keep him on the sidelines, since the implements in his tool kit are imperfect for fixing what is ailing the U.S. economy currently.
Central banks seek to stimulate demand by lowering interest rates, a powerful incentive in normal times.
The problem is, these aren’t normal times. When businesses and consumers would rather save than spend, as currently is the case in the United States, the power of monetary policy is muted. Corporations are sitting on some $2-trillion (U.S.) in profits and the household savings rate has climbed to more than 5 per cent from zero before the financial crisis, even though the cost of borrowing already is at record-low levels.
If stimulus is necessary, many economists say it must come from fiscal authorities because the power of monetary policy to change economic behaviour is at its limit.
What the U.S. economy needs is a massive jolt to demand that would encourage companies to hire and invest. The best way to do that, many economists argue, is through fiscal policy.
Fed policy makers “have done their jobs,” said Dale Mortensen, the professor at Evanston, Ill.-based Northwestern University who shared last year’s Nobel Prize in economics. “The appropriate thing to do is increase the deficit.”
The laureates diverge on what form fiscal stimulus should take.
Prof. Mortenensen urged a “big” infrastructure program that would create jobs for millions of unemployed construction workers while repairing the country’s decrepit roads, bridges and schools. Robert Mundell, the Canadian economist at New York-based Columbia University who was awarded the Nobel Prize in 1999, said the Obama administration should make the Bush tax cuts permanent and lower the corporate tax rate to 20 per cent from 35 per cent.
The professors acknowledge that their calls for fiscal stimulus are problematic, given the current political environment in Washington. Republicans in Congress held fast to a threat to allow the U.S. government to default rather than raise the legislative debt limit without stiff spending cuts, forcing the White House to abandon short-term stimulus measures.
Professors McFadden, Mortensen and Mundell all said that any fiscal stimulus should be paired with deficit-reduction measures that would kick in when the economy was back on track.
For his part, Mr. Bernanke has stressed repeatedly in recent months that the Fed can’t save the economy on its own. The White House says President Barack Obama is planning to unveil a new economic strategy early next month, but few give it much chance for success.
“Politically, it’s probably not possible to do a stimulus,” said Prof. McFadden. “We’re in a situation where anything that would be politically possible is probably not going to be enough.”