The Fed's Help Can't Last Forever

US News

Recently I sat down to lunch with Federal Reserve Chairman Ben Bernanke (and well over a thousand of our closest friends) when he addressed the Economic Club of New York. Chairman Bernanke focused his remarks on "the reasons for the disappointingly slow pace of economic recovery in the United States and the policy actions that have been taken by the Federal Open Market Committee (FOMC) to support the economy." In other words, he tried to explain why, if they're so smart, we aren't all richer.

The need to justify the Fed's action is itself an indication of how much the economic and monetary policy landscape has shifted from the time when Bernanke's predecessor, Alan Greenspan, was called the "maestro." During that extended period of (relative) economic and financial stability called "The Great Moderation," a period extending from about 1982 to 2007, we took it for granted that the Fed would act effectively to accelerate a slowing economy and restrain an over-heating one. But, as Chairman Bernanke said in his speech, by the end of 2008 the Fed had exhausted its most powerful policy weapon, setting the overnight bank lending rate, and the economy still languished. With the overnight rate already near zero, the Fed broke a sixty-year-old precedent and began using its money-creation powers to expand both the quantity and types of financial assets it would buy on the open market. This is the set of policy initiatives, known as "Operation Twist" and "quantitative easing," is now in its third round. That has expanded Fed assets to some $2.8 trillion and yet the economy still grows at 2 percent; no wonder Chairman Bernanke gives luncheon speeches.

To understand the thinking behind the Bernanke-led Fed's actions, note a speech the chairman delivered just over a decade ago at a conference held in honor of famed monetarist, libertarian economist Milton Friedman's 90th birthday. Of all the Friedman-influenced topics that he could have discussed, Bernanke, then a Fed governor, chose to review Friedman and his co-author Anna Schwartz's argument that the Federal Reserve's failure to counteract the contractionary monetary forces at work in the early 1930s resulted in, "[t]he worst economic disaster in American history, the onset of the Great Depression." Tellingly Bernanke concludes, "... abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we [the Federal Reserve] did it. We're very sorry. But thanks to you, we won't do it again." Bernanke's commitment to keeping this promise may well explain the aggressive stance the Fed has taken under his leadership.

Unpopular as my view might be, I tend to think the Fed has gotten more right than it has gotten wrong during the past five years. In particular, its decisive actions during the near collapse of the U.S. financial system in late 2008 and early 2009 to serve as the lender of last resort probably did avert a downward economic spiral reminiscent of the 1930s. I'll even accept that the 2010 second round of quantitative easing or, in the Fed's preferred term, "large-scale asset purchases" helped reduce the risk that deflation would grip the economy. Whether "Operation Twist"--selling the Fed's short-term treasury debt to buy longer term notes--or its current program of buying mortgage-backed securities, or its promise to keep rates low for another two or three years can do much to accelerate the economy seems far more questionable. In fact, the impact of each new round of Fed action has diminished, at least in terms of its impact on equity markets.

Yet the Fed doesn't intend to stop here. In his Economic Club speech Bernanke affirmed that the Fed will "...continue purchasing MBS, undertake additional purchases of longer-term securities, and employ our other policy tools until we judge that the outlook for the labor market has improved substantially in a context of price stability."

The commitment to "do something" reminds me of what it sometimes feels like to be a parent. You know you've been a big influence on what your kids do, occasionally even for the better. So when children confront a problem, a circuit switches on telling you to get involved even though you should doubt how much you can accomplish. Like an experienced parent, the Fed would be better off letting us know it's prepared to act when and where monetary policy can avert the kind of severe contraction that plagued the 1930s and that threatened to develop in 2008, but that increasingly, like maturing children, we, and importantly, the political leadership grappling with the nation's debt problems, are on our own.

Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.



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