Bernanke and the Fed’s Big Plan

By: Andrew Robertsbernanke

After months of lackluster, yet not devastating job reports, the Federal Reserve made its position clear: it stood at the ready to provide aid if the economy turned sour. In August 2012, only 96,000 jobs were added, much less than anticipated, and Ben Bernanke, chairman of the Federal Reserve, took this additional weak report to announce new monetary policy aimed at growing the economy. The Fed’s QE3 (quantitative easing) plan, announced in September, involves buying mortgage-backed securities to put additional money into the housing market and push the economy towards quicker recovery.

Normal monetary policy includes adding money into the market by buying government debt (in the form of bonds), which in turn is spent by consumers to stimulate the economy. By increasing money supply, the Fed decreases interest rates, which allows consumers to borrow money and businesses to invest at lower rates. Unfortunately, there are two problems with this policy. First, many consumers are left with large post-Great Recession debt and are unwilling to borrow any more money. Second, because the Fed has taken so much action since the recession, interest rates are virtually at 0% and can hardly go any lower. It has embraced this “zero-bound” policy, saying in January 2012 that there would be “exceptionally low levels for the federal funds rate at least through late 2014.” Because the rate is already very close to 0% (at .25% at the time this article was written), the time had come for the Fed to choose another policy.

The QE actions are different from typical monetary policy in that normal policy includes purchases of 3-month treasury securities, which only lowers short-term interest rates. Many have debated the effects of QE and Paul Krugman, the 2008 Nobel Memorial Prize in Economics recipient, said QE is “mild mitigation at best.” Whereas the Federal Reserve has enacted policies like QE3 before (QE1 and QE2), it believes this approach will work this time. The policy has multiple benefits. Functionally, it puts money into the economy and keeps long-term interests rates low, an effect that will have greater effect over time than the normal short-term interest rate manipulation. Unfortunately, even if long-term interest rates remain low, there is little the Fed can do to combat unemployment if the banks refuse to lend money. It also sends a clear message that the housing market is key to a strong recovery. Many of these securities have become “toxic” and have lost their value; those who originally took out the mortgage can no longer afford it or their house is worth less than their mortgage. This hurts the banks because they are no longer receiving money for the mortgages and it also hurts the borrower because they cannot pay the banks back, putting them in a difficult financial mess. Buying these mortgage-backed securities helps both the lenders and the borrowers and sets the housing market right side up.

Normally, these sorts of actions are taken with a definitive end point. For example, after the economic crash of 2008, the Fed bought $1.75 trillion dollars of debt from Fannie Mae and Freddie Mac. Here, the Fed announced a specific number and limit to its actions. With the new policy, conversely, the Federal Reserve tied the fate of its actions to its success. It stated that it would buy $40 billion worth of mortgage-based securities each month until the job markets showed “substantial” improvement. This decision allows the Federal Reserve flexibility and motivation to ensure that this policy works. Because it chose an arbitrary word like “substantial,” it gets to decide when to cut the program, despite what lawmakers or the public believe.

One of the greatest concerns of this action is the risk of inflation. This decision gives the Federal Reserve virtually unlimited spending power as it can print $40 billion per month until it decides that the economy has improved. With this excessive amount of money put into the economy, in addition the 2009 fiscal stimulus, many economists worry that in the long-run the United States will face extremely high inflation. Furthermore, because banks are not lending very much right now, the amount of money sitting in banks is rather high. If they start lending, inflation could spike to very high levels. Although the Fed has shared this concern with others, it likely believes that to fix the economy now is worth fighting inflation later. Mr. Bernanke, however, does not see inflation as a grave threat and says that it “is anticipated to run at or below our 2% objective,” a reasonable level of inflation. Either way, the Federal Reserve only gets this chance to fix the economy, whereas high prices are something it can bring down with different monetary policy when the financial system is in balance.

When looking at Ben Bernanke and the Federal Reserve’s economic power, it is almost surprising that their control is virtually unmatched by any other authority. Congress, of course, can pass financial laws that help stimulate or slow down the economy, but constitutional checks and balances that govern the federal government weaken its command. An extraordinary example of this is the ineffective, current 112th Congress, largely a result of the divided government between the Democratic president and the Republican House. As an independent central bank, the only confines the Federal Reserve Board of Governors has are term limits. Ben Bernanke, as Chairman, has flexed the Fed’s power as he has intervened in the economy more often than most chairmen and has become a key player in the financial system.

While this almost unbridled power seems somewhat unnerving, the Fed may be America’s only solution to this economic mess. Advocates of little to no government intervention had their opportunity; the Fed refused to act month after month of slow economic growth and the do-nothing-Congress produced no laws to help move the economy. If a no-government approach were going to work, it should have happened by now. Until at least January, when the 113th Congress is sworn in and either President Obama or Gov. Romney takes the oath of office, there is likely to be no progress from Congress and the White House. Even then, Republicans would have to take both the Senate and the presidency for there to be any policies enacted, less the same absent results from the divided government will continue. It is imperative that this policy works if this economy is going to have any sort of quick recovery. The importance of QE3 puts pressure on Ben Bernanke and the Federal Reserve and shows they must be confident that it can work.