June 22, 2010
When Caution Carries Risk
By DAVID LEONHARDT
Ben Bernanke believes that he and his Federal Reserve colleagues have the ability to lift economic growth at their meeting this week. The Fed, he has said, “retains considerable power to expand aggregate demand and economic activity, even when its accustomed policy rate is at zero,” as it is today.
Mr. Bernanke also believes that the economy is growing “not fast enough,” as he recently put it. He has predicted that unemployment will remain high for years and that “a lot of people are going to be under financial stress.”
Yet he has been unwilling to use his power to lift growth and reduce joblessness from near a 27-year high. Instead, Fed officials are expected to announce on Wednesday that they have left their policy unchanged, even if they acknowledge that the economy has recently weakened.
How can this be? How can Mr. Bernanke simultaneously think that growth is too slow and that it shouldn’t be sped up? There is an answer — whether or not you find it persuasive.
Above all, top Fed officials are worried that financial markets are fragile. They are not so much worried about inflation, the traditional source of Fed angst, as they are about upsetting the markets’ confidence in Washington. Yes, investors remain happy to lend the United States money at rock-bottom interest rates, despite our budget deficit and all of the emergency Fed programs that will eventually need to be unwound. But no one knows how long that confidence will last.
In effect, Mr. Bernanke and his colleagues have decided to accept an all-but-certain downside — high unemployment, for years to come — rather than risk an even worse situation — a market panic, a spike in long-term interest rates and yet higher unemployment. As the last few years have shown, market sentiment can change unexpectedly and sharply.
Still, you have to wonder if the Fed is paying enough attention to the risks of its own approach. They do exist. The recent data on jobless claims, consumer spending and home sales have been weak. On Tuesday, Britain announced a budget-cutting plan that will depress short-term growth there and spill over somewhat into the global economy. The necessary budget cuts in Greece and other parts of Europe won’t help global growth, either.
The main historical lesson of financial crises is that governments are usually too passive. They respond in dribs and drabs, as Japan did in the 1990s and Europe did in 2008. Or they remove support too quickly, as Franklin Roosevelt did in 1937, and then the economy struggles to escape its funk.
Look around at the American economy today. Unemployment is 9.7 percent. Inflation in recent months has been zero. States are cutting their budgets. Congress is balking at spending the money to prevent state layoffs. The Fed is standing pat, too. Bond investors, fickle as they may be, show no signs of panicking.
Which seems to be the greater risk: too much action or too little?
The Fed’s benchmark interest rate, which has been near zero since late 2008, determines the overnight rate at which banks lend one another money. The overnight bank rate, in turn, sets other short-term interest rates. But the benchmark rate has only an indirect effect on long-term rates. That’s why the 30-year fixed mortgage rates can be near 5 percent while the Fed rate is zero.
If Mr. Bernanke and his colleagues decided to take further action, their most likely move would be to bring down long-term rates. They could do so by buying the bonds that backed longer-term loans. With lower borrowing costs, households and businesses would probably spend more money. The Fed did precisely this during the financial crisis, and the drop in rates seemed to help spending.
Last week, the San Francisco Fed released a report analyzing interest rate policy since the crisis began. The report suggested that the effective benchmark rate — taking into account both the zero percent short-term rate and the bond purchases — was now roughly negative 2 percent.
The most notable part of the report, however, was what it showed the effective rate should be. Based on a formula that considers past Fed policy and current levels of unemployment and inflation, the effective rate today should be negative 5 percent. In layman’s terms, the report was saying that the Fed was erring on the side of timidity.
Mr. Bernanke and other Fed leaders do not quibble with these numbers. If anything, Mr. Bernanke has gone out of his way to distance himself from the presidents of some regional Fed banks who have begun publicly worrying that the Fed has pumped too much money into the economy and that inflation is about to rise. Mr. Bernanke has instead said inflation is subdued and pointed to surveys showing that economists expect it to remain so.
His worry is a different one.
In a recent appearance before the House Budget Committee, he spoke repeatedly about market confidence. Specifically, he mentioned “the potential loss of confidence in the markets” if Congress did not come up with a plan for reducing the budget deficit.
There is a direct analogy between the budget deficit and the Fed’s asset holdings. Neither is sustainable. Congress needs to demonstrate that it has a plan for reducing the deficit over the long haul so that investors will be confident enough to continue lending the United States money at low rates.
The Fed, meanwhile, has to show it has a strategy for selling the trillions of dollars of assets it bought during the crisis — without damaging the value of private investors’ holdings and without, at some point, igniting inflation. “The more we buy,” Donald Kohn, the Fed’s vice chairman said last month, “the more assets we will ultimately need to dispose of.” The more the Fed buys, the greater the risk that it will find the point at which the market becomes unnerved.
In the end, Mr. Bernanke’s dilemma has no certain solution. Taking more aggressive action might have only a modest effect on spending, and nobody — including the most passionate advocates for more government action — can really know how long the bond markets will stay calm. The decision comes down to weighing the probabilities and the possible outcomes.
Let’s just be clear about the risks and costs that the Fed has chosen. It is betting that, for once, policy makers are not underreacting to a financial crisis. And it is willing to accept a jobless rate of almost 10 percent, with all of the attendant human costs.
“About half of the unemployed have been unemployed for six months or more, which means that they are losing skills, they’re losing contact with the job market,” a prominent economist said at a public dinner in Washington this month. “If things go on and they simply sit at home or work very irregularly, when the economy gets back to a more normal state, they’re not going to be able to find good work.”
That economist happened to be Ben Bernanke, one of the few people with the power to do something about the situation.