Federal Reserve Chairman Ben Bernanke, when he was a professor of economics at Princeton University, evaluated the central Bank of Japan’s responses to the bursting of the asset bubble there in the early 1990s.
Bernanke dismissed the idea that zero interest rates were evidence of loose monetary policy and judged that Japan’s central bank officials “have – to a far greater degree than is justified – hidden behind minor institutional or technical difficulties in order to avoid taking action”1 to help a struggling economy.
He proposed that a central bank like Japan’s that is stuck in a so-called liquidity trap (when interest rates are zero so can’t be cut) should conduct asset-buying programs known as quantitative easing, lower the value of the currency and announce a high inflation target “in the 3-4% range … to be maintained for a number of years”.2 Bernanke ended his paper by calling on the Bank of Japan to display the same resolve that Franklin D. Roosevelt did after being elected US president in 1932 when he showed “his willingness … to do whatever was necessary to get the country moving again”.3
Wonder how Bernanke feels today now that critics use these words to call for greater actions from the Fed and the European Central Bank. Notwithstanding that both central banks have taken many inventive, non-conventional steps, the duo could do more to aid their economies, even if the biggest challenges facing their countries require political solutions. Perhaps the only valid excuse for the pair’s reluctance to take bolder moves is that such inaction piles more pressure on politicians to act.
Draghi outshines Trichet
When future academics evaluate how today’s central banks fared in extremis, the ECB’s performance under the inflexible Jean-Claude Trichet, who departed last year, will be especially slammed. Many cite the ECB’s rate increases in April and July last year as when the eurozone debt crisis veered out of control, not least of all because slowing economic growth makes it harder for governments to curb their debt burdens. Trichet’s rate increases, which boosted the main lending rate from 1% to 1.5%, were designed to lower inflation of 3% towards the bank’s 2% target.
Other marks against Trichet was that he refused to conduct unlimited purchases of government bonds by hiding behind the EU treaty clause that prevents the ECB financing eurozone debt – he “sterilised” the 220 billion euros (A$255 billion) worth of bonds the ECB bought in 2010 by withdrawing an equal amount of cash from the money supply.
Mario Draghi, who took over the ECB on November 1 last year, impressed investors and, no doubt future academics, with quick, pragmatic, almost anti-Trichet, decisions. He cut the benchmark rate in November and December (and again in July to reduce the rate to a record low 0.75%). Then came his sidestep around the ECB’s legal impediments when he used three-year repurchase agreements to give banks cash cheaply. While Draghi most likely prevented a freezing of the financial system, his repo scheme that lent banks 1 billion euros (A$1.4 billion) was flawed in that it lashed the fate of banks even closer to the direction of sovereign yields. When investors again lost confidence in public finances, the capital position of banks was undermined – hence Spain’s 100-billion-odd-euro bank bailout.
As Greece and Spain spiral further into crisis, the ECB is under pressure to assume financial-stability powers including the ability to backstop government bonds. The bank, however, has so far been wary of using such muscle given the opposition from Germany.
But at least Draghi doesn’t intend to be a cipher for German hostility to the lasting solutions to the crisis involving the central bank as Trichet was. Draghi, who says the ECB will do “whatever it takes” to save the euro, wants the central bank to re-enter bond markets so as to keep Italian, Spanish and other yields at manageable levels. But the Bundesbank and German public opinion (but perhaps not key German political leaders) remain opposed to the ECB buying sovereign bonds on the secondary market, even if it’s tied to austerity measures.
In an apparent attempt to force his will, Draghi outed Bundesbank President Jens Weidmann, with his “reservations”,5 as being the block on policy-setting board to this potentially crisis-altering plan. The outcome of this Draghi-Weidmann showdown over whether the ECB buys large amounts of bonds is shaping as significant for the euro’s fate – and assessments of whether Draghi is more than just intentions and talk.
Unmet Fed goal
In the US, Bernanke’s economic challenges are less menacing than Draghi’s, even if tax increases and spending cuts worth 4% of GDP from January 1 threaten to plunge the economy into recession and the political pressure is more personal. Presumptive Republican presidential nominee Mitt Romney has said he will effectively sack Bernanke – he won’t reappoint him for a third four-year term from 2014.
To Bernanke’s credit, when the financial crisis started in mid-2007 he reacted in conventional and unconventional terms and prevented another Great Depression. He slashed rates to zero by December 2008 and says he intends to keep them there until at least 2014. He protected money-market funds, channelled emergency money into investment banks and has conducted seven episodes of unconventional policy so far. This includes the US$2.3 trillion spent in two rounds of quantitative easing. But Bernanke is more starkly failing to meet what is commonly known as the Fed’s “dual mandate” of price stability and full employment (even though Congress set a triple goal for the Fed of “maximum employment, stable prices and moderate long-term interest rates”.)6
In January, Bernanke announced for the first time an explicit inflation target for the Fed, which he set at 2%. While price stability generally refers to suppressing inflation, it includes avoiding deflation, a destructive force because it prompts consumers to defer spending, deters business investment and boosts the real cost of debt. The US central bank is vague about what maximum employment means in terms of a jobless number. But an unemployment rate above 8% for the past 42 months exceeds its assumed jobless target of around 5.5%.
The latest reports show that consumer inflation in the US is only 1.7%, while the Fed’s preferred target, the deflator on personal consumption, is only running at a 1.5% annual pace. The Fed forecasts inflation and unemployment to respectively undershoot and overshoot its targets. The central bank should then take steps to better meet its goals, especially when a looser monetary policy will help attain the desired outcomes for inflation and unemployment. Bernanke is not facing a mutually exclusive decision, as is often the case, when central banks have to choose between targeting inflation or achieving full employment (and usually opt to control prices.)
Why won’t Bernanke do more? Maybe the lashings from Republicans are sapping his resolve or he thinks bold steps would be too political ahead of US elections in November. Perhaps he is more sanguine about an inflation rate below target than he would be about an inflation rate exceeding its ceiling. Bernanke denies this, saying the 2% target is “not a ceiling, it’s a symmetric objective”.7 Maybe two rounds of bond-buying have erased the effectiveness of such programs and he is reluctant to do another, even if there is talk the next one would be directed at mortgage-backed securities.
Critics warn that asset-buying schemes foster risky investment, drive up asset prices, can trigger inflation and are ineffective as they fail to boost demand. Richard Fisher, the president of the Federal Reserve Bank of Dallas who this year has no vote on Fed decisions, cautions against a third round of asset-buying. “If we have so much money sitting on the sidelines, what good does it do to provide more?” he asks.8 (While the head of the New York Fed has a permanent voting spot on the Fed’s 12-strong policy-setting committee, four of the 11 other regional Federal Reserve presidents serve on a one-year-rotating basis. The seven non-voting presidents attend meetings and contribute to discussions.)
Bernanke always has the option of raising inflation expectations by increasing the inflation target. Chicago Fed President Charles Evans, who has no vote on policy this year, has long called for a 3% inflation target when unemployment is above 7% and disputes that Bernanke’s inflation target is symmetrical.9 Bernanke, for his part, slams the idea of a higher inflation target as “very reckless”.10 So it doesn’t look a likely option any time soon.
The Fed and the ECB will no doubt take more steps to help their economies as they wait to see if politicians forge lasting solutions. It would be interesting, in the meantime, to find out whether Bernanke has softened his criticisms of the Bank of Japan now he has felt the burden of power. He must surely admire Roosevelt even more for how, against all expert advice, he took steps that saved capitalism in 1933.