By Daniel Hanson
Virtually all spectators to Bernanke's Jackson Hole speech will probably be disappointed, as Bernanke sits in a no-win position. Faced with sluggish economic growth, a strong desire exists for the chairman to announce a third round of quantitative easing at Jackson Hole, which is unlikely given the Fed's recent comments and fresh, positive financial data. Yet, the short-term rally is clearly not enough to cause the Fed to reverse its unprecedented accommodative stance.
The Fed Open Market Committee gave an uncharacteristically candid glimpse of its thought process following its August meeting, indicating that, given the continued tepid expansion of the U.S. economy, "additional monetary accommodation would likely be warranted fairly soon." This hint at more QE has proven that words can do a lot, as markets rallied through August, but not everyone likes this prospect.
Inflation a Real Threat?
The GOP is very publicly concerned that the Fed is driving up inflation, spelling doom for seniors on fixed incomes specifically and for consumers generally. The Republican platform thus contains harsh language about the Fed, promising a revival of a gold standard commission and a more extensive audit of the Fed's operations.
It's hard to argue that inflation is a looming specter when all signs indicate that prices are drifting downward. Core inflation, the Fed's favorite measure, has trended downward for four months and now stands at 1.1 percent on an annualized monthly basis. Headline inflation has followed a similar pattern, dropping to well below 2 percent. Inflation expectations, meanwhile, are down as well. According to the Cleveland Fed, the public expects inflation to remain below 2 percent for the next decade, a view reflected in both the price of gold and the spread of Treasuries to inflation-protected Treasury notes.
The corollary to the GOP's position is the implication that the Fed should tighten, or at least stop accommodating. But such a move would cause markets to roll over hard, which would certainly impact seniors disproportionately. Large losses in equity and private bond markets would be devastating to those who rely on their investment returns for day-to-day survival — the exact group the GOP purports to protect by reversing Fed action.
Still No Solution
But a far more salient question regards what reasonable economic conditions would actually cause the FOMC to raise the Fed funds rate. The Fed's current logic says such a move would come when macroeconomic trends demonstrate a FOMC-acceptable trend. For 27 years from 1980-2007 the U.S. economy grew at three percent while central bankers wished for four, a condition that could presumably be met by expanding the money supply just a bit so long as inflation expectations remained anchored. The trend never became fully FOMC-acceptable. Given the trend of GDP over the next two years looks to be well below three percent, the Fed's current stance is cause for alarm.
Supposing QE3 comes and provides some boost to equity markets for several months, the Fed's balance sheet will have quadrupled in size, as a conservative guesstimate, since 2008. While this expansion won't have showed up fully in broader money, it has already had a transformative effect on liquidity, causing the observable demand for money to disappear. This situation — a classic liquidity trap — will only be amplified by additional QE, and the consequence — continued impotence of Fed policy on real economic variables — will persist.
This is particularly unsettling given the Fed's own rules-of-thumb regarding accommodation. The guidance of the so-called Taylor Rule, which attempts to balance the tradeoff between GDP growth and the price level, saw its assumptions — and thus policy efficacy — break down as interest rates declined to record lows. Inflation targeting, once intellectually pioneered by Princeton professor Ben Bernanke, has been nearly impossible to maintain as repeated rounds of easing have failed to put to bed deflation risks.
The New Fed Mandate
Meanwhile, the long-standing rule of thumb, the size of the monetary base as a function of Fed's liabilities, was jettisoned in 2008 when the Fed funds rate approached zero and the Fed started rabidly buying agency debt and mortgage-backed securities. They have no announced path for unloading these securities, and no historical precedent exists for unwinding similar investments. This shift from traditional, neutral monetary policy to credit allocation in specific sectors marked a radical shift from historical Fed policy in an effort to circumvent the growing powerlessness of the Fed to fix problems.
Against this backdrop, it is hard to see what sorts of macroeconomic changes would have to take place for the Fed to reverse policy and raise rates or unwind its balance sheet. No economic shifts on the foreseeable horizon could persuade the Fed to raise rates, given the language of recent policy statements. If retirees, endowments, pensions, corporate financial arms, and other investors are banking on help from the Fed in the former of higher rates of return, they will continue to be disappointed at least through 2014, and probably much further.
QE3 may well be in the near future, but investors should beware. The Fed has demonstrated they don't have a plan for a sustainable future, and until they do, markets will continue to rise on short-term cash binges and fall as this snake oil elixir wears off. With each successive round of easing that fails to produce longer term growth, the Fed loses a little credibility and invites more criticism from meddling politicians.
Daniel Hanson is an economics researcher with the American Enterprise Institute.