What More Can Bernanke Do to Rev Up the Economy?

What More Can Bernanke Do to Rev Up the Economy?

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There won’t be much mystery about what Ben S. Bernanke, the chairman of the Federal Reserve, thinks about the economic outlook when he testifies before the Senate Banking Committee on Wednesday.

In a word, his outlook has darkened. Though Fed officials have long warned that unemployment will remain very high for several years, according to the latest Fed forecast they now expect the economic recovery to be even slower than projected back in April. And they are worried things could get worse.

But the big question remains unanswered: Why don’t Bernanke and his Fed colleagues want to do more to rev up the economy?

At most other times, the answer would be that the Fed is balancing its twin goals of full employment and low inflation.  If unemployment is too high but prices are inching higher, the central bank has to make choices and may decide to err on the side of higher unemployment. 

That’s not the case right now. The Fed’s latest forecasts, released one week ago, show that officials expect both employment and inflation to be lower than what they would like through 2012. 

For practical purposes, Fed officials consider “full employment’’ to be a jobless rate of about 5 percent and “price stability’’ to be annual inflation of 1.5 percent to  2 percent.

But Fed officials are expecting that unemployment will stay above 9 percent this year, hover between 8.3 percent and 8.7 percent in 2011 and remain above 7 percent in 2012.  In fact, Fed officials have said they don’t expect the job market to fully recover for five or six years.

At the same time, they expect inflation to remain lower than many would like.  The Fed’s favorite barometer of “core” inflation, which excludes energy and food prices, is expected to inch up by no more than 1.5 percent in 2012.   In fact, some officials are worried about the possibility of deflation – a decrease in the general price level of goods and services that occurs when the annual inflation rate falls below zero percent.

Fed forecasts aren’t necessarily accurate.  But they are important because they aren’t just forecasts. They also  represent what Bernanke and Co. want to happen.  

That’s because the forecasts assume that that economic activity over the next several years will be the result of “appropriate” Fed policies.  The policies might turn out to be wrong, but they reflect what officials think at the moment is “appropriate” for reaching their goals.  So if the policies are what officials consider “appropriate,’’ the expected results have to be “appropriate’’ too.

The question among many economists is why the Fed is tolerating such high unemployment when it also expects very low inflation.   Indeed, there were rumors on Wall Street on Tuesday – probably false – that Bernanke might encourage banks to lend more by cutting the interest rate that the Fed pays banks on excess reserves they park at the Fed.

Bernanke is certain to get an earful from anxious members of the Senate Banking Committee today and possibly even more from the House Financial Services Committee on Thursday. These hearings may be a little rough for Bernanke in part because Fed officials are uncertain about their forecasts and are nervous about all the money they have already pumped into the economy.

The Fed has kept its benchmark interest rate at virtually zero ever since December 2008 and repeated last month that it plans to keep the rate down for “an extended period.”   It has also pushed down long-term interest rates by creating new money out of thin air and buying up more than $1.5 trillion worth of Treasury bonds and mortgage-backed securities.

Fed policymakers are increasingly split over whether this could fuel inflation sooner than the current numbers suggest.  They have already stopped the Fed’s purchases of long-term Treasuries and mortgage-backed bonds.  

But a handful of inflation hawks are worried, and would like to set the stage for actually raising rates.  The most visible hawks include Thomas Hoenig, president of the Kansas City Fed, and Jeffrey Lacker, president of the Richmond  Fed.  

But minutes from the Fed’s June meeting show that many policy makers were rattled by evidence of slower growth and rising fear in financial markets.  Indeed, Fed officials agreed to start looking at new measures to stimulate growth, in case they become necessary.

The June minutes make it clear that officials were more uncertain than usual about their forecasts.  That is normal at times when the economy is changing directions, because  incoming data is jumpy and sometimes contradictory.  But the inevitable uncertainties have been magnified in this recovery, because the Federal Reserve’s aggressive and unconventional measures have taken it into uncharted waters.

But analysts say there is another reason for the Fed’s hesitation: it is not clear that creating vast sums of new money will have much impact.

The issue becomes clear by looking at a chart compiled by the St. Louis Fed of “excess reserves” that commercial banks hold on deposit at Federal Reserve banks.

When the full force of the financial crisis hit in late 2008, the Fed created massive amounts of money.  But most of that money simply ended up at banks as “excess reserves” – money they didn’t want to use and simply deposited back at the Fed.

According to the St. Louis Fed, the volume of “excess reserves”  soared from almost zero in early 2009 to more than $1.1 trillion in early 2010.  The volumes have declined slightly in recent months, but they still total more than $1 trillion.

The problem is that banks remain either unable or unwilling to ramp up their lending, largely because they don’t see enough profitable business opportunities. 

For Fed officials, the good news is that the all the extra money isn’t fueling inflation because it isn’t being used. But the bad news is that the extra money isn’t spurring much growth either.

Compounding the puzzle, long-term interest rates have actually fallen since the Fed stopped using new money to buy up long-term bonds.  Other things being equal, bond prices should have fallen and interest rates should have edged up  when the Fed stopped its purchases.  

But that didn’t happen, in part because financial turmoil in Europe sent investors fleeing to the comparative safety of U.S. Treasury securities.  On top of that, worries about slowing growth made investors and corporations more reluctant to borrow and invest.

All of this leaves Bernanke in an odd position.  In 2003, when he was a new governor at the Federal Reserve Board, he gave a famous speech in which he asserted that the Fed would always be able to spur growth by printing money. He even suggested, metaphorically, that the Fed could drop loads of money by helicopter – leading pundits to nickname him “helicopter Ben.”

Today, eight years later, the Fed can still drop loads of money on the financial system.   But the reality is that “Helicopter Ben’’ may be less able than he once thought to put that money to work.

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