In a speech at the ECB last week Chairman Bernanke rigorously defended the FOMC’s November 3rd decision to restart a program of quantitative easing. This follows in the wake of a wave of criticism from a wide-ranging group that includes economists/lawyers, the Republican leadership, foreign governments, and even Sarah Palin. The speech and its surrounding events are remarkable for many reasons.
First is the substance of the speech itself. Chairman Bernanke made several important points. He noted that the divergent growth paths for developed and emerging economies called for different policies but were breaking down incentives for global policy cooperation. Additionally, he observed that export-motivated exchange-rate policies (he didn’t mention China by name) were reminiscent of the beggar-thy-neighbor policies pursued under the gold standard in the Great Depression era. These are not sustainable, could generate internal inflation for countries experiencing capital inflows, and could again destabilize the world’s economies. Put bluntly, countries with undervalued currencies have no business complaining about the Fed’s quantitative easing policies and the implications for the value of the dollar, since their own policies are part of the problem.
Chairman Bernanke also spent some time trying to make the case that the unemployment situation, low inflation, and slow-growth problems in the US called for more monetary and fiscal stimulus. He put a strong stake in the ground about the Fed’s commitment to the decision to make some $600 billion in additional Treasury purchases through the beginning of next year. He also indicated a commitment to an inflation target of about 2%, which incidentally has crept up, in a stealth move, to a single target-rate objective, from the 1 to 2 percent range suggested by previous FOMC committees. He repeated the point made in a recent speech at Jekyll Island that he objected to calling the FOMC’s asset purchase program quantitative easing. Instead he tried to make the case that the policy was simply a variant of conventional attempts by the Fed to lower interest rates. The Chairman also suggested that the FOMC’s policy was purely domestic in focus. To the extent there were implications for the dollar exchange rate, they were simply an unintended, but logical, consequence of the policy. Interestingly, he didn’t assert the reported claim made in a closed session with Congressional leaders that the policy may create between 700 thousand and 1 million jobs within two years. Lastly, with regard to winding down the QE policy when the time came, he made only a few brief comments. He asserted that the combination of interest on reserves and asset sales would enable the Fed to limit the outbreak of inflation. We have argued in other commentaries that this is not so obvious. The bottom-line conclusion from reading the speech, however, is that one cannot be optimistic that the greater good will trump short-term, self-interested national policies when it comes to nations being willing to make the needed sacrifices to achieve a better functioning global market system.
Second is the Chairman’s choice of venue and subject matter for such a speech. To move to an international stage outside the US and to tackle two subjects – fiscal policy and exchange rate policy – suggests how pressured the Fed must feel at this moment. Both topics have typically been viewed as “third rails” by former Fed chairmen, and they addressed them at their own peril. Chairman Greenspan, for example, has been widely criticized for his forays into fiscal policy, such as his support for the Bush tax cuts in the early 2000’s. And the subject of exchange rates has been especially off limits. To venture into these areas at this time poses risks to the Fed’s independence, especially with the possible ascendance of Congressman Ron Paul as head of the subcommittee overseeing the Federal Reserve.
Third, the external tension is heightened by perhaps the most divergent set of views within the FOMC on the appropriate path for policy that one can remember. Several factions have emerged, with the dissent of President Hoenig on one end and the strong cases made recently by Presidents Evans and Rosengren and Vice Chair Yellen in support of the need for quantitative easing on the other side. In a recent interview, President Plosser suggested that the full $600 billion of purchases was still not certain. In his mind it was state-contingent upon the path of the economy. However, of all the rhetoric on the subject, the position taken by Governor Warsh in both his November 8th speech in NY and companion piece in the Wall Street Journal is most perplexing. In that speech, he made a strong point that bears quoting:
“We can no longer afford to tolerate economic policies that are preoccupied with the here-and-now. Chronic short-termism in the conduct of economic policy has done much to bring us to this parlous point… By now, policy makers should be skeptical of the long-term benefits of temporary fixes – one-off Band-Aids and short cuts – to do the hard work of restricting the world’s great economic power.”
He went on to note:
“Fiscal authorities should resist the temptation to increase government expenditures continually to compensate for shortfalls of private consumption and investment. A strict diet of fiscal austerity has great appeal, a kind of penance owed for the excesses of the past.”
Warsh voiced considerable skepticism in his speech that the Fed could solve all the nation’s economic problems. His wonderful punch line was:
“The Federal Reserve is not a repair shop for broken fiscal, trade, or regulatory policies.”
But he said much more. In both pieces he indicated that he viewed the possible effects of the new QE policy as uncertain. The policy entailed considerable risks, including the possible disruption of asset price signals, masking the true fiscal condition of the US and inducing foreign governments to engage in exchange-rate manipulation.
The irony is that despite criticizing fiscal authorities for short-termism, he turned around and voted for more quantitative easing, in what can only be labeled an extreme example of monetary policy short-termism. The Fed is attempting to accelerate job creation and to inflate the economy to stimulate spending in the short run, with the promise that it will reverse policy in a timely fashion before bubbles occur or inflation rears its ugly head. Is Governor Warsh expressing buyer’s remorse or is it an admission of a policy mistake?
One can’t envy Chairman Bernanke at this point. It is often said that one of the functions of an independent central bank is to take the political heat when pursuing politically unpopular policies. Well, the oven is hot and the turkey is roasting.