It Didn't work in Japan, or Europe, but we'll Make it work - and don't call it QE (Economist's View)

Friday, November 19, 2010

Bernanke: Rebalancing the Global Recovery

Ben Bernanke defends the Fed (text of speech):

Bernanke Faults China for ‘Persistent Imbalances’, by Sewell Chan, NY Times: Ben S. Bernanke ... plans to argue Friday that currency undervaluation by China and other emerging markets is at the root of “persistent imbalances” in trade that “represent a growing financial and economic risk.” ...

For the last two weeks, the Fed has been criticized for its Nov. 3 decision to inject $600 billion into the banking system through next June, resuming an effort to lower long-term interest rates. ...

Mr. Bernanke’s speech argues that unemployment in the United States is at “unacceptable” levels, and gingerly wades into the fiscal policy debate roiling Washington.

“In general terms, a fiscal program that combines near-term measures to enhance growth and strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve,” Mr. Bernanke will say. ...

Mr. Bernanke’s remarks amount to an endorsement of crucial elements of President Obama’s economic approach. But that endorsement ... could further stoke criticism by Congressional Republicans, who say the Fed is defying voters’ skepticism about large-scale government intervention in the economy and setting the stage for inflation later, and by foreign officials, who fear the Fed is trying to weaken the dollar to make American exports more competitive.

Mr. Bernanke ... will reiterate his argument that the Fed felt compelled to act because inflation is so low ... and unemployment so high... “In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years,” he will say. “As a society, we should find that outcome unacceptable.” ...

The text includes indirect responses to domestic and overseas critics. He intends to argue that the Fed “remains unwaveringly committed to price stability” and that buttressing growth is “the best way to continue to deliver the strong economic fundamentals that underpin the value of the dollar.”

The speech addresses the anxieties of Brazil, Thailand and other emerging economies, which fear that a surge of foreign capital will drive up prices and interest rates.

If exchange rates were allowed to move freely, Mr. Bernanke will argue, emerging markets would raise interest rates — and allow their currencies to appreciate — even as advanced economies like the United States maintained expansionary monetary policies. That would curb the emerging markets’ trade surpluses and shift demand toward domestic consumption and away from export-led growth.

Instead, Mr. Bernanke plans to say, currency undervaluation in big surplus economies has led to unbalanced growth and “uneven burdens of adjustment.” ...

Antonio Fatás wonders why the Fed seems "so obsessed with ensuring that inflation always stays at or below 2%." Allowing inflation to rise above 2% temporarily could help the Fed with its goal of spurring the economy and increasing employment:

How negative should real interest rates be?, by Antonio Fatás: Standard monetary policy is about setting short-term nominal interest rates. Most macroeconomic models assume that inflation is sticky (constant) in the short run and by moving nominal interest rate the central bank is actually setting the real interest rate and by doing so influencing spending (consumption and investment) decisions. Of course, these spending decisions might depend on long-term interest rates and therefore we also need to understand how short-term interest rates affect both nominal long-term rates and inflation over a longer horizon (where we cannot assume that inflation is constant).

We can use this logic to think about the most recent quantitative easing policies announced by the Fed. That's what Mark Thoma does very well ... in his blog. One issue that I am missing in his analysis is how we think about real interest rates (not just nominal) in the current context. This is very much related to the defense that some Fed officials have done over the last hours of their policies. For example, in his interview with the WSJ, Janet Yellen argues that QEII (the next round of quantitative easing) is not intended to raise inflation. That the Fed is happy with an inflation rate below but close to 2%.

I understand the importance of having a "low and stable" inflation target but we need to keep in mind that these targets should be interpreted in a medium-term framework, we are not asking the central bank to deliver a constant 2% inflation every month, quarter or year. And given that the Fed has refused to adopt a formal inflation target to keep its flexibility to set inflation on a short-term basis, why do they seem so obsessed with ensuring that inflation always stays at or below 2%? Even the ECB that is some times seen as putting too much emphasis on inflation has let the Euro inflation rate go above 2% during many of the months it has been in existence, so a little flexibility above 2% in the communications of the Fed might not hurt.

We can also think about what all this implies for real interest rates, by asking: what should the level for real interest rates be given current economic conditions? We know that with short-term rates at zero (and they cannot go lower) sending a strong message about inflation being below 2% sets a floor for how low real interest rates can go (the floor is -2%). Estimates of what the appropriate real interest rate is in the current situation (which tend to be made within the context of a Taylor rule) vary but some suggest that real interest rates might need to be even lower than that [By the way, I find this related post by Krugman very useful to understand the logic behind negative real interest rates].

In addition, we have the issue of the dynamics of expectations and actual inflation. It might be that Fed officials by sending a very strong message about not wanting to increase the inflation rate above 2% will keep inflation expectations low and actual inflation remains significantly lower than the 2% "target". My guess is that their conservatism when it comes to inflation is the result of the strong criticism that they have received (both at home and abroad), which has sent them into a defensive position where they need to reassure everyone that their current policies are not about raising inflation. But this might not be optimal, while anchoring long-term expectations of inflation around a low target is reasonable, there is nothing wrong in admitting that one of the goals of the current policy is to ensure that inflation stops falling and that we go back towards 2% or even higher in the short-term.