What Now, Chairman Bernanke?

As a Princeton University professor, Ben Bernanke castigated the Bank of Japan in 2000 for a "case of self-induced paralysis" that led to years of stagnation and deflation. Now the Federal Reserve chairman may be allowing the central bank to fall into the same trap.

It's not as though Bernanke has been sitting on his hands. "The Fed has been a lot more proactive than the Bank of Japan was back then," says Alan S. Blinder, a former vice-chairman of the Fed's board of governors who is now a professor at Princeton. Under Bernanke, the Fed has conducted two rounds of quantitative easing, pumping money into the banking system through the purchase of close to $1 trillion in Treasury securities. That gave banks abundant funds to lend out to businesses and consumers. Bernanke has also lowered the rate the Fed pays the banks to hold their excess reserves to a minimal 0.25 percent, in essence encouraging the banks to seek higher returns by lending their money to commercial borrowers.

So where's the paralysis? By all but ruling out another cycle of bond purchases in recent statements, Fed officials have left themselves with few options to counter the slowing growth and rising unemployment of the past few months. This raises the risk that the U.S. recovery will remain, as Bernanke himself has said, "frustratingly" sluggish.

Fed officials are betting that the slowdown will prove short-lived, removing the need for further action. The thinking is that growth will pick up from July through December as the shocks from Japan's earthquake and an oil-price surge fade. Private economists agree. After growing at a 2.3 percent annual pace in the second quarter, the world's largest economy will expand at a 3.2 percent rate in the second half of the year, according to the median forecast of 67 economists surveyed by Bloomberg.

The danger is that, once again, such forecasts will prove too optimistic. In April most Fed policymakers were looking for the economy to expand by 3.1 percent to 3.3 percent this year. On June 22 they said they expected 2011 growth of 2.7 percent to 2.9 percent.

Allen Sinai, president of Decision Economics, says the chance that the U.S. will suffer a growth recession—that's when the economy expands at 1 percent or less for at least two quarters—has doubled recently, to 10 percent. "If I were at the Fed, I'd be looking at ways to do something like QE3," says Sinai. That would probably involve another round of bond purchases to make even more money available for low-cost loans. Fed officials don't seem so inclined. "We've done enough," Federal Reserve Bank of Dallas President Richard W. Fisher said in a June 13 speech.

When Bernanke raised the idea of QE2, he stressed the Fed's determination to avoid deflation. Those fears have eased with a rise in oil and food prices, says Roberto Perli, a former Fed economist who is a managing director at International Strategy & Investment Group in Washington. Consumer prices rose 3.6 percent in May from a year earlier, vs. a 1.1 percent gain in November, when the Fed began buying $600 billion worth of Treasury securities.

The stimulus helped nudge the inflation needle forward and gave investors confidence and cheap money to buy stocks. Yet quantitative easing has had a less discernible impact on growth, raising questions inside the Fed about the efficacy of further action, Sinai says. Opposition to QE2—congressional Republicans have attacked it for sparking inflation—also makes QE3 less likely.

Bernanke defends the decision not to pursue QE3, telling reporters on June 22 that with inflation higher and job growth stronger than last year, "the current outlook is significantly different." He argued that the Fed was not repeating Japan's mistakes and said the U.S. central bank stood ready to take more action if needed to aid the economy.

Blinder thinks the Fed is being "a little too passive." He wants the Fed to cut to zero the rate it pays banks on the excess reserves it holds for them. That would remove banks' incentive to park money with the Fed. Even better, says Blinder, the Fed could effectively charge banks for holding their reserves by paying a negative interest rate. More likely is that Bernanke will keep short-term interest rates, now around 0.25 percent, at that low level for even longer. "It is becoming increasingly likely that the Fed will be on hold until 2013," says Perli.

Another option, according to Michael Feroli, chief U.S. economist at JPMorgan Chase (JPM), is for the Fed to commit to an enlarged balance sheet for an extended period, thus reassuring investors that it won't quickly reduce the huge holdings of securities it accumulated through QE1 and QE2. A sell-off of the Fed's Treasuries would risk a crash in the bond market.

Should the rise in inflation prove transitory, as Bernanke has suggested, the Fed should plan more bond purchases, says Joseph Gagnon, an ex-Fed official who is a senior fellow at the Peterson Institute for International Economics. "If [Bernanke] says the little blip in inflation is temporary and it's going to go back below target, and he says he's very unhappy with the unemployment rate, then why isn't he doing more?" Gagnon asks. "It's really ironic. It's a self-induced paralysis."

The bottom line: The Fed may need to rethink its wait-and-see policy as economists cut their estimates for full-year growth for the U.S.

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