Fed Policy: Bernanke Bides His TimeMichael Wallace
Federal Reserve Chairman Ben Bernanke delivered his semi-annual monetary policy report before the House Committee on Financial Services on Feb. 24, largely reviewing the current state of the economic outlook, monetary policy, transparency, and regulatory reform as the crux of his written testimony. While the Fed has in fact been taking technical steps to prepare to exit from its "exceptionally extended" ultralow interest rate policy, Bernanke made it clear that policy will remain accommodative for now.
In two key passages, Bernanke went to some length to downplay any policy implications from recent moves on the discount rate, the revival of the Treasury's Supplementary Financing Program for the Fed, closure of the majority of emergency lending facilities, and the gradual end of the Fed's purchases of mortgage-backed securities—all essentially reverse-engineering past emergency measures. Characterizing those steps as part of the "normalization" of policy, Bernanke said that monetary policy remained largely unchanged since the January statement, though that does not preclude tightening conditions at some stage with appropriate tools such as interest on reserves, reverse repos, and the like.
"These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve," Bernanke said in his testimony. "These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC."
Bernanke said that although the fed funds rate is likely to remain "exceptionally low" for an extended period, the Fed will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures as the expansion takes hold. "Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time."
On the economic outlook, Bernanke summarized the consensus view as a "nascent economic recovery" on the order of a GDP expansion at roughly 4.0% during the second half of 2009, supported by "highly stimulative monetary and fiscal policies." A large chunk of that gain, however, was from inventory rebuilding, and fiscal support is likely to wane later this year as stimulus spending trails off. Other positives have been an overall recovery in consumer spending, some stability returning to the payroll figures, rising business investment in equipment and software, and rebounds in global growth and trade.
On the flip side, unemployment remains near 10%, and the "job market remains quite weak" as highlighted by a doubling of long-term unemployment to more than 40% of the total pool of the unemployed. As Bernanke noted, "increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time."
Bernanke underscored that the Feb. 18 discount rate hike, to 0.75% from 0.5%, was "successful," saying that it did "not engender any additional tightness in the financial markets." This highlighted the Fed's intent to communicate the technical adjustment without disturbing the markets. He also said the Fed would not be monetizing the debt, and emphasized the importance of Congress and the Administration in returning to a sustainable fiscal path.
Questioned about the IMF report suggesting that a 4.0% inflation rate target might be safer given deflationary risks, Bernanke suggested that it would merely ratchet up the risks of higher inflation, despite its appeal.
The Fed chief said that unemployment remains the biggest problem currently. On the topic of fiscal issues, he doubted that there would be a credit-rating downgrade of the U.S., and didn't expect there would be any default. However, he placed those issues in the lap of Congress, as the Treasury has the ultimate authority in servicing the nation's debt. He agreed that the current budget path is unsustainable but noted that it's not necessarily a longer-run problem, though signs of a credible fiscal exit strategy would be comforting to the markets.
Bernanke touched on some other hot topics: He said that there were no U.S. plans to help bail out Greece, or any other foreign nation, nor purchase debt from other countries, in response to a typically thorny question from Representative Ron Paul (R-Tex.). Bernanke highlighted commercial real estate as the biggest issue facing the U.S. credit markets currently, noting the ongoing problems with malls and retail spaces as the crux of weakness in the sector. Difficulties remain with lending by small and mid-size banks as well. The credit drought on small businesses is one area the Fed could improve upon, he said (underscored by the FDIC study reporting the lowest lending since 1942), without elaborating on the details.
Market reaction was fairly muted in relation to the subtlety of the Bernanke speech and caution on the economic and policy outlook. Treasury yields declined, spurred additionally by back-to-back declines in consumer confidence on Feb. 23 and new home sales on Feb. 24. The benchmark 10-year yield fell below 3.70%, compared with highs near 3.82% following the Fed's discount rate hike on Feb. 18. Major stock indexes posted gains near 1%, while the U.S. dollar index drifted slightly lower to 80.75.
On balance, the Fed chief was fairly measured in his assessment of the monetary policy and economic outlook, while wagging the usual finger at fiscal deterioration. This did not disguise the fact that the Fed continues to take necessary baby steps to begin to normalize policy from its emergency stance. Still, the Fed's ultra-accommodative policy remains in place.
Bernanke will get a chance to revisit these themes when he wraps up his two-day testimony in front of a Senate panel on Feb. 25.
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