Following Bernanke Means Using Precedent of Unprecedented Policy
The success of the next Federal Reserve chairman, be it Janet Yellen, Lawrence Summers or someone else, will depend less on their grounding in monetary policy orthodoxy than on their readiness to reach beyond it.
That flexibility defines the leaders of the world’s principal central banks: the Federal Reserve, the European Central Bank and the Bank of Japan. All three responded to economic shocks by casting off institutional dogma and broadening their missions.
At the Fed, Chairman Ben S. Bernanke engineered the most unconventional experiment in U.S. monetary-policy history using trillions of dollars in direct bond purchases to lower long-term interest rates and expanding the central bank’s role as lender of last resort. The ECB’s Mario Draghi pushed the central bank’s goals beyond narrow price stability, pledging unlimited support to countries that sign up for fiscal restructuring. BOJ Governor Haruhiko Kuroda set out to double Japan’s monetary base to end two decades of stagnation.
“The unconventional policy is going to have to become conventional,” said Adam Posen, former Bank of England Monetary Policy Committee member who is now president of the Peterson Institute for International Economics in Washington. “Central banks are going to have to act on a wide range of assets and directly in credit markets. It is a very different world.”
Bernanke, 59, was the first to break the mold. At the start of 2009, when the U.S. economy was contracting at a 5.3 percent annual rate, the Fed chairman was preparing a step no one had taken before: more than $1 trillion of mortgage-backed securities purchases to keep credit flowing to housing markets.
In 2008, the Fed chairman had seen the financial crisis spread beyond the banking system to financial companies and securities markets. He opened special facilities to lend to U.S. government bond brokers, buy the commercial paper of U.S. corporations and banks and finance the securitized loans to students, car buyers, small businesses and credit card borrowers. Having cut the benchmark lending rate to zero by December 2008, Bernanke turned to a new approach, expanding direct bond purchases in 2009 to keep long-term rates low.
“What was incredible to me, and still even carries weight with me today, is the rapidity with which he and the broader Fed architecture moved from seeing the world from a traditional lens to the full unconventional slate of tools,” said Michael Gapen, who was then a section chief in the Fed’s Division of Monetary Affairs and is now senior U.S. economist at Barclays Plc in New York. “You are talking about a 60-day period where Bernanke turned the institution on its head and started thinking in an extremely unconventional world.”
Former Federal Reserve Chairman Alan Greenspan said in an interview that taking bold action as a central bank looks easier than it is. Central banks are creatures of legislatures, which can be suspicious of extraordinary actions, and financial markets can react in unexpected ways, he said.
Greenspan said there is an unspoken consensus about keeping in the bounds of orthodox policy that is difficult for any central banker to violate.
“If we are right, but the consensus is wrong, we are tolerated,” Greenspan said. “If we are wrong, and the consensus is right, we get pilloried. So there is an acute bias to staying with short-term policy and that is what limits the range of action.”
Sweden’s Riksbank, one of the pioneers of central bank innovation as early as the 1990s with its communications and inflation targeting regime, has lately struggled with providing more stimulus out of concern it might inflate a credit bubble. The 12-month inflation rate measured by a consumer price index was below the central bank’s 2 percent target for all of 2012, and has been negative for the last three months. Unemployment (SWUERATE) over the past year has averaged about 8 percent, while the Rikbank’s benchmark interest rate has fallen just a half percentage point to 1 percent.
“I’ve never seen as much criticism against the Riksbank as we’re seeing right now,” Robert Bergqvist, chief economist at SEB AB in Stockholm and former head of research at the central bank, said in an interview. “The market believes the bank will be unsuccessful in getting inflation back to 2 percent,” he said, referring to a survey conducted by SEB.
Bernanke approached the financial crisis by expanding the lender-of-last-resort authority to include loans to institutions other than banks because stabilizing financial markets would create conditions to allow him to pursue his mandate to foster full employment and stable prices.
The European Central Bank, which by statute is responsible for pursuing low and stable inflation, faced the same sort of choice as the fiscal crisis swept across Europe in 2010 and began to threaten the entire euro project.
Former ECB President Jean-Claude Trichet defended the inflation mandate, raising interest rates twice in 2011, even while offering unlimited liquidity to banks across the region.
A more aggressive approach proved necessary as the crisis simmered for months. Draghi, Trichet’s successor, pushed the mission further by offering banks cash for longer than ever and pledging unlimited bond purchases for countries signing up for fiscal restructuring. Draghi, who took over the ECB in November 2011, is drawing fire from Germany’s Bundesbank for his willingness to stretch the rules. He credits the bond plan with preventing a euro breakup.
The BOJ’s Kuroda similarly abandoned the model of his predecessor, Masaaki Shirakawa, who had periodically expanded asset purchases in response to a weakening in the economic outlook or appreciation in the yen.
Kuroda, in an effort to revive credibility on price stability and growth, on April 4 unleashed a two-year program designed to double the monetary base, through purchases of securities dominated by government bonds.
“Shirakawa was convinced that deflation stemmed from weak demand and external forces, not monetary policy, whereas Kuroda sees monetary policy as the way to get out of deflation,” said Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group AG in Tokyo and a former BOJ official who’s unrelated to the ex-governor. “It’s possible that Kuroda could ease further if prices don’t rise, even if growth is solid -- it’s unlikely his predecessor would’ve done that.”
Both Summers and Yellen have likewise shown a readiness to embrace unconventional policies when confronting crises.
Summers was undersecretary for international affairs at the U.S. Treasury in 1994, as Mexico suffered a run on its dollar reserves after letting its currency slide. Faced with the risk of a Mexican default, a potential international crisis in financial markets, and congressional reluctance to increase U.S. aid, Summers and Treasury Secretary Robert Rubin tapped the Exchange Stabilization Fund, established in 1934 to promote orderly foreign exchange markets, for a $20 billion package to backstop Mexico.
Using the fund to backstop a foreign nation’s reserves had immediate political costs. Pressed by Representative Bernard Sanders, a Vermont independent who is now a U.S. senator, Congress eventually approved a law that made any use of the fund of more than $1 billion subject to lawmakers’ approval. Not using it might have had even higher costs as a default by Mexico might have spilled over into capital flight in other emerging markets, while also damaging U.S. growth. As it was, the limitation amendment expired in 1997.
“It without a doubt stabilized the Mexican economy, local financial markets and safeguarded deep exposures by U.S. corporations and investors,” said Lawrence Goodman, president for the Center for Financial Stability in New York, an independent research organization focused on financial markets. A default “would have had a profound impact on the U.S. economy.”
More recently, Summers, as director of the White House National Economic Council in 2009 and 2010, helped draft an $830 billion economic stimulus program and an unprecedented rescue of the auto industry.
Yellen’s role in the crisis entailed devising monetary policy for an expansion that hasn’t progressed fast enough to bring down the unemployment rate, which stood at 7.6 percent last month. She has a record of innovation as one of the architects of the Fed’s forward guidance on the short-term policy rate. Yellen also led the subcommittee that devised the publication of interest rate forecasts by policy makers for the first time in January 2012.
“Yellen is absolutely qualified as a macroeconomist dealing with monetary policy issues,” said John Ryding, chief economist at RDQ Economics in New York who has worked at the Bank of England and the New York Fed. “But in terms of broader issues of flexibility in financial crisis and looking at how to get things done, I think Larry Summers more than has the edge there.”
Summers’s record suggests he wouldn’t hesitate to engage the White House, Congress or the Treasury in policies as he needed them. Such reach, though, could be risky if it involves the Fed in politics or credit policies that favor specific industries.
While both Summers and Yellen are “great academic economists,” Yellen would probably be more mindful of the Fed’s political independence, said Julia Coronado, chief economist for North America at BNP Paribas in New York and a former member of the Fed board staff.
“She has been dedicated to the institution for much of her professional life and believes deeply in the mission of the Fed and its independence,” Coronado said.
Every crisis requires central banks to balance policy innovation with public credibility. Too little action can create doubts about a central bank’s power and effectiveness, while too much action can bring raise suspicion of overreach.
“Reputation comes from being credible for a long time,” said Michael Bordo, director of the Center for Monetary and Financial History at Rutgers University in New Brunswick, New Jersey. “In crisis periods, the essence of central banking is to act decisively and boldly.”
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