Much Ado About Bernanke

There has been a lot of talk recently about Ben Bernanke, he of the Wall Street Journal op-ed and the multiple Congressional appearances. (Hey, can anyone put me in touch with his agent?*) At the risk of seeming ignorant (or revealing myself to be ignorant), I must say I don’t really understand what the fuss is about.

The question seems to be whether the Fed will be able to tighten monetary policy fast enough when necessary to dampen the potential inflationary effect of its current expansive monetary policy (Fed funds rate at zero, buying long-term securities, etc.). My read on the situation is as follows:

  1. Almost everyone agrees that expansive monetary policy has been appropriate during the crisis and recession to date.
  2. Everyone agrees that at some point monetary policy will have to be tightened.
  3. No one knows when that will happen.
  4. Everyone agrees that because policy has been so expansionary recently, tightening monetary policy when necessary will be more difficult than usual.
  5. Everyone agrees more or less on what tools will be available to the Fed.
  6. No one is certain the Fed will or will not be successful, because there are no relevant datapoints to compare it to.
  7. No matter what Bernanke actually thought, he would still have to say exactly what he is saying this week.

I don’t see much in there worth arguing about.

As Catherine Rampell says, a more interesting question is when the Fed will start tightening policy. This is the kind of thing that can set the Fed against the administration, as stereotypically one focuses on inflation and the other on unemployment. But since most people think it is too early to start now, that debate would be purely speculative at the moment.

* He does need a grammar checker, though. His first sentence – “The depth and breadth of the global recession has required a highly accommodative monetary policy” – contains an error in subject-verb agreement.

By James Kwak

28 thoughts on “Much Ado About Bernanke

  1. James,

    I would be careful saying that the Fed’s actions have been “expansionary”.

    The increase in the monetary base has been parked in excess reserves. It has not been spent/lent, and it therefore has not increase aggregate demand.

    Its surprising that most economists think that base growth has been “expansionary” but not “inflationary”. The truth is, its been neither.

    Of course, the base growth did prevent a steep contraction in the money supply caused by widespread bank failures. That is raising AD from where it “could have been”, not from where it “has been”.

    The Fed wants everyone to believe they can raise AD and not cause inflation. The truth is, to raise AD, the excess reserves must be lent/spent, and the “exit plan” is supposed to prevent exactly that!

  2. As has been discussed (separately) by Perry Mehrling and Paul Krugman, the rapid expansion of the Fed’s balance sheet has been due to it acting as the primary financial intermediary last fall and winter. Essentially, it became the liquidity backstop for much of the commercial paper market. As Mehrling notes, this expansion is being “widely misunderstood” as an expansion of the monetary base through quantitative easing.

  3. So, there are two things about the global recession that “have required”? But “required” has to agree with the subject, “global recession”, doesn’t it, not the two things or properties of it? It’s still a singular subject that has two properties.
    Anyone know what this is called?

  4. Perhaps it’s like saying:

    “The length and breadth of the Matisse painting has required art students to learn color theory.”

    compared to:

    “The length and breadth of the Matisse painting have required art students to learn color theory.”

    Okay, so the real subject of Bernanke’s sentence is not “global recession”, but “depth and breadth”. Or Bernanke’s sentence could be re-written as:

    The length of the global recession and the breadth of the global recession have required, etc.

  5. ISLM,

    Exactly. The Fed now has a problem. The amount required by banks as liquidity (roughly $900b) is also an amount too-great to be deployed into the economy. Using an effective reserve ratio of 1%, it would create $90tr in aggregate demand.

    So the Fed must promise, as it has done, to withdraw the money BEFORE its lent. That means, basically, that monetary policy is hamstrung. The Fed cannot use it to raise aggregate demand without risking furious inflation.

    Right now this doesn’t seem to be a problem. But what if the economy “double-dips” in 4q? Can the Fed credibly promise to raise AD without risking an inflationary overshoot? I would say no, unless it made that promise and SIMULTANEOUSLY withdrew excess reserves. That would be confusing and ineffective, to say the least.

    So I think there’s a good chance the Fed, to save the banks, has taken monetary policy “out of the game.” If we really have deflation risk, we are in trouble.

  6. Aggregate Demand. Basically the amount of nominal total spending in the economy.

  7. I’ve always thought this site was supposed to be educational. So when Simon and many posters go overkill with the acronyms I find it highly annoying. You want to use acronyms fine, but ad them in parenthesis. That is a big pet peeve of mine. Knowledge of acronyms is not a sign of intelligence now nor will it ever be. Let people know the acronyms so when the jackass congressman uses them on TV you know what it is, but explain it.

  8. Some of this is about positioning for reappointment.

    I used to think Bernanke had little chance of reappointment. Afterall, he was appointed by Bush, he said that the subprime problem was “contained”, and he had his hand in the bailouts. Obama has lots of reasons to pick someone else if he so chooses.

    However, I’m beginning to think that he might win out.

    The wild card is Larry Summers. I think that he wants the job desperately and this might be his only chance.

  9. Larry Summer’s gargantuan ego DEMANDS that he be Federal Reserve Chairman. Unfortunately for him Bernanke is doing a good job. President Obama has no reason to appoint a man (Summers) with zilcho political skills. Summers wears his ego like a huge emblem on his chest. 0% chance of Summers getting the job.

  10. depth and breadth could be viewed collectively, i.e. neither was sufficient by itself to require accommodative policy, as in ‘bacon and eggs’ is a good breakfast.

  11. I have not seen any discussion on what the implicit guarantees on backstopping bank liabilities has done to increase the potential for inflation by making these liabilities more liquid. Can anyone shed some light? Thankyou

  12. Hey Alex,
    This column written by Alan Blinder is about 1 month old. But I think it still holds true now and answers your question for the short-term. Keep an eye on how those indicators he mentions in the column change over time. Should help you gauge it.
    Long-term nobody really knows.

  13. Summers is a complete disaster in his current office. He completely rolled Obama on the stimulus. Were he ever appointed to as Fed Chair, we might as well return to using salt as a unit of exchange

  14. The fallout from the financial crisis, in terms of aggregate demand (AD) and income, has been much larger than anyone expected or forcasted. We are currently locked in a liquity trap because we entered the recession with such low rates because Alan Greenspan is simply an uglier Arthur Burns. Moreover, the paradox of thrift is driving down income as people and firms deleverage. More ugly times ahead, sadly.

  15. The article assumes tightening will occur when the Fed sees a rise in inflation. I wonder, however, if we might not see premature tightening if the dollar starts falling precipitously as foreign holders dump their dollar assets or refuse to buy Treasury notes and bonds. In that case we may confront the worst set of circumstances: raising rates without a firm recovery.

  16. Just so. The 10 year TIPS rate is about 1.8 right now. Blinder’s article is still spot on.

    What we need is another $500 billion in fiscal stimulus. Half to the states for immediate backfill. Half to reduce payroll taxes for a period of time.

  17. Given the rise in the domestic private savings rate as a result of the paradox of thrift, we can finance the fiscal deficits internally.

  18. “Everyone agrees that because policy has been so expansionary recently, tightening monetary policy when necessary will be more difficult than usual.”

    As written, that does not quite make sense to me. How about this amendment?

    “tightening monetary policy sufficiently when necessary will be more difficult”

    Does that make sense?

    It sounds like there is an asymmetry between monetary tightening and expansion. IIUC what William White has written, tightening by raising rates would have made it *easier* to expand later if necessary. Have I got that right?

    My real question is this. If future monetary tightening is problematic, does it make sense to coordinate increased fiscal stimulation, as by a jobs program, with gradual monetary tightening, so that later tightening, if necessary, would be easier to effect and less drastic in its consequences? Would such a coordination help achieve a balance between concerns about inflation and unemployment?

  19. Blinder doesn’t touch on a very important aspect of the fed’s reserve build-up – namely its composition. JDH raises this point. The fed is engaging in fiscal policy and putting taxpayers at risk for some serious losses. For example, look at the size of its recent MBS purchases.

  20. Thanks David, I am a non-economist. But I find what you and ISLM have to say very serious.

    In sum it sounds like: The Fed saved the banks. But there is no real economic stimulus. The $900 billion is a backstop for the bad debt in the banking system. Because there is a recession people are saving and deleveraging, banks are deleveraging, and this is deflationary. The Fed cannot print more money for real expansion, without causing inflation, unless it withdraws the $900 billion held in reserve. A case of damned if you do and damned if you don’t.

    Have I got this right?

    But you’ve lost me here. What is an “an effective reserve ratio of 1%,” and why would $900 billion lead to $90 trillion in aggregate demand?

  21. Tippy,

    $90tr probably overstates it — its an upper bound.

    The idea is that banks need to put a dollar of required reserves away for every $100 of deposits. So if the $900b gets lent, that creates $899b of new deposits, which in turn get lend, which create $898b, and so on. The multiplier of 100x is basically one divided by the reserve ratio. The ratio is actually higher than 1%, but banks achieve 1% by sweeping checking deposits into interest-paying overnight balances, which carry no required reserves.

  22. Thanks David, very interesting. Did some reading in Wikipedia on fractional reserve banking … said a fish not knowing the water she swims in.

  23. I know that it is a small thing, but I appreciate the grammatical criticism. This has become the single most common mistake, other than using I or myself instead of me, as appropriate. The President has a continuing problem with using the indefinite article “a” when “an” is the right choice of article. He does it so uniformly, and yet he is a wonderful speaker and capable writer. What’s up with that?

    On all other levels, I agree with your Bernanke analysis.

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