July 13th, 2011
Econintersect: Federal Reserve Chairman Fed Chairman is making his semi-annual pilgrimage to the US Congress explaining monetary policy. As the Fed has been very public recently, his explanation of the current state of the economy has been covered by Econintersect in June 2011 FOMC Meeting Minutes Has Dour Feel and Bernanke 2nd Press Conference: The Economy Is Temporarily Softer.
Bernanke listed temporary economic shocks which are creating the current malise:
- The run-up in prices of energy, especially gasoline, and food has reduced consumer purchasing power.
- The supply chain disruptions that occurred following the earthquake in Japan caused U.S. motor vehicle producers to sharply curtail assemblies and limited the availability of some models.
Chairman Bernanke stated there was uncertainty in economic projections:
Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate.
The Chairman considered "moderate" growth is the best that will occur in the short and medium term. The monetary policy solutions to changes in expectations are:
On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.
On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy. Accordingly, the Committee has been giving careful consideration to the elements of its exit strategy, and, as reported in the minutes of the June FOMC meeting, it has reached a broad consensus about the sequence of steps that it expects to follow when the normalization of policy becomes appropriate. In brief, when economic conditions warrant, the Committee would begin the normalization process by ceasing the reinvestment of principal payments on its securities, thereby allowing the Federal Reserve's balance sheet to begin shrinking. At the same time or sometime thereafter, the Committee would modify the forward guidance in its statement. Subsequent steps would include the initiation of temporary reserve-draining operations and, when conditions warrant, increases in the federal funds rate target. From that point on, changing the level or range of the federal funds rate target would be our primary means of adjusting the stance of monetary policy in response to economic developments.
Bernanke did mount a defence over QE2 during his testimony.
When we began this program, we certainly did not expect it to be a panacea for the country's economic problems. However, as the expansion weakened last summer, developments with respect to both components of our dual mandate implied that additional monetary accommodation was needed. In that context, we believed that the program would both help reduce the risk of deflation that had emerged and provide a needed boost to faltering economic activity and job creation. The experience to date with the round of securities purchases that just ended suggests that the program had the intended effects of reducing the risk of deflation and shoring up economic activity. In the months following the August announcement of our policy of reinvesting maturing and redeemed securities and our signal that we were considering more purchases, inflation compensation as measured in the market for inflation-indexed securities rose from low to more normal levels, suggesting that the perceived risks of deflation had receded markedly. This was a significant achievement, as we know from the Japanese experience that protracted deflation can be quite costly in terms of weaker economic growth.