Federal Reserve Chairman Ben Bernanke is taking flak from international policy types for his latest foray into quantitative easing. He had to defend his actions to economists and former policy makers at a Jekyll Island, Georgia, conference last week. He even had to submit to a “cease and desist” order from Mama Grizzly Fed Watcher extraordinaire, Sarah Palin.
There’s one group that’s sticking with him: the next generation of would-be central bankers.
College students playing Fed at the annual “Fed Challenge” Monday in New York were much more willing to give Bernanke the benefit of the doubt. With the benchmark overnight rate at the “zero-bound” for almost two years -- the faux Fed strives to sound like the real Fed -- unemployment too high and inflation too low, the Fed had few options other than buying more Treasuries to bring down long-term rates, the students generally agreed.
“This is just monetary policy,” Bernanke said at the Jekyll Island gathering in an attempt to dispel the notion that QE2 was some “strange kind of thing,” the outcome of which was unpredictable.
It’s not the unpredictability that upsets the critics, including the late Milton Friedman as channeled by Fed historian Allan Meltzer in a Nov. 4 Wall Street Journal op-ed. (The Journal’s David Wessel got a different take.) It’s just the opposite. Printing money eventually leads to higher inflation.
With history offering up ample evidence, it’s treacherous for the Fed to set out to raise inflation expectations on the loopy notion it can increase that component of nominal long-term rates while holding everything else constant. More likely, nominal long rates will rise in sync with real rates.
If it’s any consolation, none of the six teams that presented their economic outlook, risk analysis and policy recommendations to me and three other judges Monday did any better than the real Fed explaining the viability of this strategy.
Nor did they score points for their response to my question about the channels through which monetary policy operates. What happens, I asked, if long rates don’t fall, if a strengthening economy and expectations for a shorter “extended period” of zero percent short-term rates pushes long rates in the opposite direction? (Answer: It works through the quantity of bank reserves and faster money supply growth.)
That’s what happened in 2009, “an awful time to own Treasuries” even though the Fed purchased $300 billion of them between April and October as part of QE1, said Jim Bianco, president of Bianco Research in Chicago.
‘What If’ Happened
The yield on the 10-year Treasury note rose from a low of 2 percent at the end of 2008 to 3.84 percent at the end of 2009. The total return for the year was -9.71 percent, according to Bianco. The 30-year bond delivered a -26 percent return to investors, its worst year ever, according to Bianco, who has data on railroad bonds going back to 1871.
The good news for the economy was that yields on other debt instruments moved in the opposite direction, an infrequent occurrence. Corporate bonds, mortgage-backed securities and high-yield debt delivered positive returns of 19.76 percent, 5.87 percent and 57.5 percent, respectively, according to Bank of America Merrill Lynch indexes.
The Fed can hope this divergence between Treasuries and other debt securities repeats itself, but I wouldn’t count on it given the record low yields at which corporations are borrowing.
Besides, if a healthier banking system is the means to the end of more business lending, a flatter yield curve is counterproductive to bank profits.
The New York Fed is one of five district banks participating in this year’s Fed Challenge. Thirty-six teams of three to five undergraduates from colleges in New York, New Jersey and southern Connecticut participated in Monday’s competition.
One team in my group came in character, with one student playing Ben Bernanke and the others posing as Fed presidents known to be less enthusiastic about the benefits or advisability of QE2.
Another team included outside advisers to the Fed in the form of Stanford’s John Taylor and former Fed chief Paul Volcker. Volcker’s stand-in lacked his signature cigar but was, not surprisingly, an inflation hawk. The Taylor surrogate used the “Taylor Rule,” a model that uses the difference between actual and potential output and between actual and target inflation to generate the appropriate funds rate, to show that the funds rate was too low from 2002 to 2005, and his own modified Taylor Rule to suggest the funds rate is too low now.
Least Bad Option
Suggesting “a rule-based policy after announcing QE2 would not be appropriate,” Team 2 concluded.
Alan Greenspan showed up at the Fed Challenge -- in spirit. Team 1 referred to the financial crisis as a “once in a 100- year storm,” a favorite claim of the maestro who navigated us through a minimum of three in his 18-year tenure as Fed chairman.
I sensed Greenspan’s presence in Bernanke’s rationale for QE2 as well. If the Great Depression was the Fed’s fault -- it was, according to Friedman and economist Anna Schwartz -- Bernanke wants to ensure it doesn’t happen again. Toward that end, he seems to be adopting Greenspan’s risk-management approach. (Or is it risky management?)
In a nutshell, the consequences of doing nothing and being wrong are worse than those of doing something and being wrong. It’s the least bad option.
On that the faux Fed and real Fed seem to agree.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
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