In theory, a pimpled 16-year-old could grasp the economic plan that Federal Reserve Chairman Ben Bernanke outlined Wednesday.
The former Princeton University professor geared his lesson about revving up the economy – but not overheating it – for motor heads.
“To use the analogy of driving an automobile, any slowing in the pace of purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not to beginning to apply the brakes,” Bernanke said, adding that the goal is to bring the economy to a “reasonable cruising speed.”
In other words, the Fed aims to reduce its monetary stimulus, but not bring everything to a screeching halt.
The stock and bond markets heard his explanation – and much like a skittish teenager with a learner’s permit, started crashing. The Dow Jones industrial average plunged 1.35 percent. Amid a bond sell-off, the yield on 10-year Treasury notes spiked to a 15-month high of 2.35 percent.
It’s evidence of how much markets have depended on the Fed punching the accelerator, something that, obviously, cannot happen indefinitely.
In a unique disclosure, the Fed chairman modestly claimed he was “deputized” by the 12-person Federal Open Markets Committee – the regional bank presidents and Fed governors who set monetary policy – to explain the highway going forward.
He delivered his explanation directly to reporters, instead of including it in the carefully worded (“terse,” according to Bernanke) statement that the committee issued after ending its two-day meeting on Wednesday afternoon.
Ever since the housing bust and the financial crisis erupted in 2008, the gist of Fed policy has been to spur economic growth by pushing down interest rates.
It did this first by slashing the benchmark interest rate it controls to near zero percent. The Fed plans to consider raising rates after the 7.6 percent unemployment rate falls to 6.5 percent. That could be sometime in 2015.
But what gets all the heat and vehicular metaphors is a policy known as “QE3.” That bit of geek slang stands for the third round of quantitative easing.
Here’s how it works: The Fed can further reduce interest rates by snapping up bonds on the open market. It’s a way to inject money into the economy. So each month under QE3, the central bank buys $45 billion worth of Treasury notes and $40 billion worth of mortgage-backed securities. This reduces the supply of the debt in the market, which leads to higher prices and lower interest rates.
At some point later this year, when the economy is strong enough, Bernanke said the Fed would start to buy fewer bonds until the unemployment rate hits 7 percent. He predicted that figure would be reached in the middle of next year, at which point the shopping spree comes to an end.
As Bernanke explained, the Fed would still be stimulating the economy even without any additional purchases. The economy benefits from the more than $3 trillion accumulated in the Fed’s portfolio. In fact, to support home prices, The Fed plans to hold onto its mortgage-backed securities. “Holding all of those securities off the market will still continue to put downward pressure on interest rates,” he said.
So buckle up, America. Here is what the Fed chairman sees in the windshield:
Keep Your Eyes on the Road Signs – Everything Bernanke said Wednesday depends on what the monthly jobs reports and economic data shows. The Fed is not blindly following a timeline, but it’s mapping a course based on evidence of economic progress.
If job hiring stalls for the next few months, the Fed might as well push its foot down harder on the gas pedal. All of this matters, since plenty of hazards still exist in the economy. The resolution of the debt ceiling showdown this fall could disrupt the economy, possibly shrouding the country in uncertainty or leading to sharp cuts in government spending that inhibit growth.
You Wouldn’t Know It, But the Economy Is Kind of Roaring – Unemployment is still historically high. Fed officials on Wednesday projected that Gross Domestic Product would increase at a less than stellar 2.3 percent to 2.6 percent this year.
But Bernanke noted that government tax hikes and spending cuts have hurt growth by about 1.5 percent of GDP. If Capitol Hill merely had a neutral impact, the economy would be climbing at a decent 4 percent clip. This suggests to him some resilience in the rebounding home prices. Higher home values contribute to the wealth effect and improve consumer confidence and spending.
Bernanke May Be Leaving, But He Will Still Call the Shots ¬¬– President Obama said during an interview this week that Bernanke – after eight years – had stayed longer at the Fed than he was “supposed” to.
Several Fed watchers interpreted that as a de facto and somewhat tasteless way of firing him before his term as chairman officially draws to a close at the end of January. Bernanke refused to comment on “personal” issues.
Speculation favors current vice chairwoman Janet Yellen as his successor.
But as Bernanke revealed Wednesday, a “consensus” exists on the open market committee plan to still unwind QE3—even once he returns to civilian life.
Inflation Is (Temporarily) Too Low – James Bullard, president of the Fed’s regional bank in St. Louis, voted against the statement issued Wednesday by the policy. His colleagues estimate that core inflation this year could be 1.2 percent to 1.3 percent, well below the target of 2 percent.
Bernanke said that he, too, is worried about low inflation, but he sees it as a temporary phenomenon. If the current levels overstay their welcome, this would be a sign of slack in the labor market and for the Fed to adopt even looser policies – possibly increases to the bond purchases in QE3.
One other committee member, Esther George of the Kansas City Fed, voted against the continuation of QE3 on the grounds that the central bank was already being too aggressive.
Bernanke Will Admit It If He’s Wrong – Bernanke is comfortable adjusting his playbook if the economy takes a U-turn. It’s rare for the economy to ever adhere perfectly to Fed forecasts, or for a Washington powerbroker to announce policies with a dose of humility.
“We have no deterministic or fixed plan,” said the chairman. In fact, judging by the inexact art of economic forecasting, Bernanke acknowledged, “Something else will most likely happen.”