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U.S. Federal Reserve chairman Ben Bernanke addresses U.S. monetary policy with reporters in Washington after announcing another round of quantitative easing on Sept. 13, 2012. (JONATHAN ERNST/REUTERS)
U.S. Federal Reserve chairman Ben Bernanke addresses U.S. monetary policy with reporters in Washington after announcing another round of quantitative easing on Sept. 13, 2012. (JONATHAN ERNST/REUTERS)

Martin Wolf

Bernanke makes an historic choice Add to ...

Ben Bernanke, chairman of the Federal Reserve, has persuaded his colleagues to make a bold decision. By a majority of 11 to one, they decided last week to undertake a monthly program of asset purchases aimed at the labour market. Is this riskless? No. Does it make sense? Yes, because the results of doing nothing would be far worse.

As the press release of the open market committee stated: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.” This is also “consistent with its statutory mandate”, to foster “maximum employment and price stability”.

Mr. Bernanke elaborated the argument for such action in the speech he delivered last month at the symposium at Jackson Hole, Wyoming, organized by the Federal Reserve Bank of Kansas City. This contained an extraordinary sentence: “The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last many years.” I congratulate Mr. Bernanke for this ethical response. I applaud him for recognizing that the Fed not only can but should do something about this dire situation.

The September economic projections of members of the Federal Reserve Board and Federal Reserve Bank presidents reveal why people who think like Mr. Bernanke about the evils of elevated unemployment should favour action. The “central tendency” of these projections is for an unemployment rate of 6.7 to 7.3 per cent even in 2014. Worse, the collapse in the employment rate that occurred in 2008 shows no sign of reversal. In the Fed’s view, the explanation for persistently high unemployment and low employment is inadequate demand. Thus, joblessness will stay high until growth accelerates. In the words of the press statement, “without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions”.

Significantly, a paper presented at the Jackson Hole symposium entitled “The United States Labour Market: Status Quo or A New Normal”, co-authored by Edward Lazear, a well-known conservative economist, provides support for the Fed’s view. It conclude that no structural changes can explain changes in unemployment over recent years. The pattern is consistent with exceptionally high cyclical unemployment. “It is the demand, stupid.” This cannot be surprising. Between 1990 and 2007, nominal U.S. GDP - also a measure of aggregate demand - grew at a trend annual rate of 5.4 per cent. It then went over a cliff: in the second quarter of 2012, it was as much as 14 per cent below its pre-2008 trend. Worse, the gap between trend and actual levels has continued to grow. All this suggests a prolonged and disturbing weakness in aggregate demand.

The Fed’s plan is to buy mortgage-backed securities of the government-sponsored agencies, Fannie Mae and Freddie Mac, at a rate of $40-billion a month. It will continue to lengthen the maturity of its assets and reinvest the principal repayments from its holdings of agency debt and mortgage-backed securities in yet more agency securities. These actions will raise the Fed’s holdings by about $85-billion a month and so should, it argues, put downward pressure on long-term interest rates, support mortgage markets and help to make broader financial conditions more accommodative. Above all, the Fed is committed to continuing with this policy until the labour market improves substantially.

Predictably, the Republican party is outraged. Mitt Romney, the Republican presidential candidate, reacted at once by stating that the third iteration of “quantitative easing” would merely provide a “sugar high”. This response is no surprise: Republicans have consistently opposed any and all attempts to use fiscal or monetary policies to ameliorate the recession. I do not know whether they believe in their liquidationist views or have sought to deny Barack Obama’s administration any success in reviving the economy. A part of me wishes they had enjoyed the chance to apply their liquidationist philosophy. The results would surely have matched those of the early 1930s: an economic catastrophe with long-lasting political results. So the wiser part of me is grateful that the people in charge were far more responsible. Quite properly, the Fed has sought to mitigate the results of the financial collapse of 2008 and the subsequent private deleveraging.

Will the Fed’s new approach work? On this, there must be questions. The Fed has been running ultra-loose monetary policies since late 2008 and interest rates on long-term bonds are already extremely low. Mr. Bernanke argues that the Fed’s asset purchase programs have raised output by almost 3 per cent and private employment by more than two million jobs above what they would otherwise have been. Yet, since interest rates are already so low, the new action is unlikely to achieve as much again. It is far more likely to be helpful than transformative.

In a lengthy discussion of monetary policy “at the interest-rate lower bound”, also given at Jackson Hole, Michael Woodford of Columbia University argues for an explicit nominal GDP target, for fiscal stimulus and for close co-ordination of monetary and fiscal policies. But tighter co-ordination is inconceivable in the United States. If the Fed did announce a plan to get nominal GDP back to its 1990-2007 trend by, say, the fourth quarter of 2016, it would need to deliver a 45 per cent increase from the second quarter of this year. That is an indicator of the scale of the demand shortfall. Needless to say, such a target is hugely unlikely.

Critics argue that the new Fed policy will not only fail to work as hoped, which is likely, but will do vast damage, which is far less so. Many have been prophesying hyperinflation for years. This fear is misguided. Unconventional policies do indeed create costs and risks. But the costs and risks of deficient demand are far greater. The Fed has decided to err on the side of expansion. That is surely right. It is, in truth, more likely to achieve too little of what it seeks than too much.

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