When we last left off on this blog, the central banker of the world's largest economy was sending some odd signals to the marketplace. Despite a sluggish global economy with inflation nary to be found, despite a national economy with plenty of spare capacity, Federal Reserve chairman Benjamin Bernanke was talking about tapering off of quantitative easing. At a time when China has its own problems and Europe can't agree on much of anything, this is a curious decision.
In his New York Times column today, Paul Krugman tries to figure out Bernanke's thinking:
One answer might be that the Fed has quietly come to agree with critics who argue that its easy-money policies are having damaging side-effects, say by increasing the risk of bubbles. But I hope that’s not true, since whatever damage low rates may do is trivial compared with the damage higher rates, and the resulting rise in unemployment, would inflict.
In any case, my guess is that what’s really happening is a bit different: Fed officials are, consciously or not, responding to political pressure. After all, ever since the Fed began its policy of aggressive monetary stimulus, it has faced angry accusations from the right that it is “debasing” the dollar and setting the stage for high inflation — accusations that haven’t been retracted even though the dollar has remained strong and inflation has remained low. It’s hard to avoid the suspicion that Fed officials, worn down by the constant attacks, have been looking for a reason to slacken their efforts, and have seized on slightly better economic news as an excuse.
And maybe they’ll get away with it; maybe the economic recovery will strengthen and all will be well. But rising interest rates make that happy outcome less likely. And now that everyone knows that the Fed is eager to slacken off, it will be hard to get interest rates back down to where they were.
Fed speculation is a fun game perfect for blogging, so can I add my two cents here? First, I do doubt Krugman's reasoning. The cross-national evidence is pretty overwhelming that Bernanke's embrace of quantitative easing was the right call, and it wouldn't take much effort for the Fed to make that point. Furthermore, Bernanke is not going to get reappointed, which means he's in endgame strategy mode right now. And finally, departing officials tend to be more blunt and caustic with critics rather than accommodating (see: Tim Geithner's congressional testimony for most of 2012).
I think there are two possibilities going on here. The first, simpler hypothesis is that Bernanke did a lousy job of communicating the Fed's intentions last week. Let's call this the Hilsenrath Hypothesis, named after the well-sourced-in-the-Fed Wall Street Journal reporter who can blow over CNBC bloviators with a single huff and puff. After markets reacted, Fed officials started trying to clarify things to Hilsenrath. Which leads to stories like today's in the WSJ:
One problem the Fed now faces is that in signaling its plans for the so-called quantitative-easing program, Mr. Bernanke might have led investors to believe the central bank is going to rein in all of its easy-money policies sooner or more aggressively than it actually expects.
The Fed isn't just buying bonds; it also has long held short-term interest rates close to zero, and has said since December it will keep its benchmark federal-funds rate there until the jobless rate falls to at least 6.5%. Mr. Bernanke likens the two levers to driving a car: When it reduces its bond purchases, that will be like lightening the pressure on the accelerator; when it starts raising rates, it will be akin to tapping the brake.
Many investors appear to have missed Mr. Bernanke's signals that the Fed might wait longer than expected before raising short-term rates. He said on Wednesday that the 6.5% unemployment rate threshold might be too high and that the Fed might decide to keep rates low for long after the rate drops below that level, especially if inflation remains low.
Other Fed officials seem to be on board with him. According to projections released after the meeting, only four Fed officials saw short-term interest rates rising before 2015, while 15 saw rates remaining near zero until 2015 or 2016.
In theory, that should reassure investors that borrowing costs are going to stay relatively low for years. But futures markets indicated investors now think the Fed is going to move rates up sooner, not later.
There is one other possibility, however, which the title of the post gives away. Let's call this possibility the Basel Belief. The Bank for International Settlements is the international regime for central bankers and regulators. Bernanke is a member in good standing of this central banker's club. As it turns out, last week the BIS issued their annual report. Here's how it opened:
Originally forged as a description of central bank actions to prevent financial collapse, the phrase “whatever it takes” has become a rallying cry for central banks to continue their extraordinary actions. But we are past the height of the crisis, and the goal of policy has changed – to return still-sluggish economies to strong and sustainable growth. Can central banks now really do “whatever it takes” to achieve that goal? As each day goes by, it seems less and less likely. Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances. And, most of all, central banks cannot enact the structural economic and financial reforms needed to return economies to the real growth paths authorities and their publics both want and expect.
What central bank accommodation has done during the recovery is to borrow time – time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth. But the time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.
Yes, in some countries the household sector has made headway with the gruelling task of deleveraging. Some financial institutions are better capitalised. Some fiscal authorities have begun painful but essential consolidation. And yes, much of the difficult work of financial reform has been completed. But overall, progress has been slow, halting and uneven across countries. Households and firms continue to hope that if they wait, asset values and revenues will rise and their balance sheets improve. Governments hope that if they wait, the economy will grow, driving down the ratio of debt to GDP. And politicians hope that if they wait,
incomes and profits will start to grow again, making the reform of labour and product markets less urgent. But waiting will not make things any easier, particularly as public support and patience erode.
Alas, central banks cannot do more without compounding the risks they have already created. Instead, they must re-emphasise their traditional focus – albeit expanded to include financial stability – and thereby encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever larger quantities of government securities. And they must urge authorities to speed up reforms in labour and product markets, reforms that will enhance productivity and encourage employment growth rather than provide the false comfort that it will be easier later.
Shorter BIS: we are tired of bailing out political ineptitude, and the time for this moral hazard to stop is now.
This is a doubling down of last year's BIS annual report, which pretty much conveyed the same message. And it seems like Bernanke has heard that message and is trying to signal to political actors that they should get their act together.
While this would explain Bernanke's behavior.... it really makes no sense whatsoever. It doesn't take a deep dive to see that the United States has gone the furthest in private-sector deleveraging, and has made rapid progress in taming its public budget deficits. Furthermore, if the weird British spellings weren't a big giveaway, this New York Times story by Jack Ewing and James Kanter makes it clear that the BIS's ire is primarily targeted at Europe, not the United States.
So of these two hypotheses, count me as buying the Hilsenrath Hypothesis. But if I'm being perfectly honest, I'm saying that primarily because it's the most rational explanation. Enough crazy s**t has happened in macroeconomic policy over the past few years that I have to allow for the possibility that maybe some weird form of central banker groupthink has affected Bernanke.
What do you think?
Daniel W. Drezner is professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University.