Ben on the Hill: Monetary Policy

Federal Reserve Chairman Ben Bernanke is testifying to the House Budget committee today. Below is the monetary policy part his prepared testimony and my reaction/translation of it. I posted earlier on the economic outlook portion of his testimony. Later I will post on the fiscal policy part of his testimony.

Monetary Policy

“Although the growth rate of economic activity appears likely to pick up this year, the unemployment rate probably will remain elevated for some time. In addition, inflation is expected to persist below the levels that Federal Reserve policymakers have judged to be consistent over the longer term with our statutory mandate to foster maximum employment and price stability.

“Under such conditions, the Federal Reserve would typically ease monetary policy by reducing its target for the federal funds rate. However, the target range for the federal funds rate has been near zero since December 2008, leaving essentially no room for further reductions.

“As a consequence, since then we have been using alternative tools to provide additional monetary accommodation. In particular, over the past two years the Federal Reserve has further eased monetary conditions by purchasing longer-term securities — specifically, Treasury, agency and agency mortgage-backed securities — on the open market. These purchases are settled through the banking system, with the result that depository institutions now hold a very high level of reserve balances with the Federal Reserve.”

An economy operating far below potential, and very low rates of core inflation, would make it an easy call to cut the Fed Funds rate. The problem is you can’t cut it below zero, which is where we have effectively been for over 2 years now. Buying longer-term treasuries (instead of very short-term treasuries as it would normally do in its open market operations) is a way around that problem.

“Although large-scale purchases of longer-term securities are a different monetary policy tool than the more familiar approach of targeting the federal funds rate, the two types of policies affect the economy in similar ways. Conventional monetary policy easing works by lowering market expectations for the future path of short-term interest rates, which, in turn, reduces the current level of longer-term interest rates and contributes to an easing in broader financial conditions. These changes, by reducing borrowing costs and raising asset prices, bolster household and business spending and thus increase economic activity.

“By comparison, the Federal Reserve’s purchases of longer-term securities do not affect very short-term interest rates, which remain close to zero, but instead put downward pressure directly on longer-term interest rates. By easing conditions in credit and financial markets, these actions encourage spending by households and businesses through essentially the same channels as conventional monetary policy, thereby strengthening the economic recovery. Indeed, a wide range of market indicators suggest that the Federal Reserve’s securities purchases have been effective at easing financial conditions, lending credence to the view that these actions are providing significant support to job creation and economic growth.”

Based on the movement of long-term rates since the second round of “quantitative easing” was announced, the policy has not been very effective. They have gone up rather substantially, but from extremely low levels. Before the announcement, the bond market was expecting deflation, not inflation. That is the only plausible reason that the 10-year T-note was yielding less than 2.5% (now around 3.7%).

I would expect a continued rise in longer-term rates, although not as dramatic as what we have seen over the last three months or so. A good way to play this move is the Ultra-Short Treasury ETF (TBT).

Deflation can be very destructive to the economy. It raises real interest rates and teaches consumers to sit on their wallets and wait for prices to fall. QE2 has taken that fear off the table.

One extremely important transmission mechanism that Bernanke failed to mention — the thing that has translated the buying of these longer-term assets into increased activity in the real economy — is a weaker dollar. That makes U.S. firms more competitive abroad, and also means that at the margin, U.S. buyers will buy more U.S.-made products rather than imported products.

The vast improvement in our net export position was the key story in the fourth quarter GDP growth. While a rising trade deficit shaved 3.50% points off of growth in the second quarter, and 1.7 points from the third quarter growth rate, it added 3.44 points to growth in the fourth quarter, or more than the net growth from the rest of the economy combined.

I would note, though, that net export growth and inventory lead growth are a bit of a see-saw, as increased imports often show up as higher inventories. However, given the choice between improved net export-led growth and inventory accumulation-led growth, net export-led is FAR better and more sustainable.

“My colleagues and I have said that we will review the asset purchase program regularly in light of incoming information and will adjust it as needed to promote maximum employment and stable prices. In particular, we remain unwaveringly committed to price stability, and we are confident that we have the tools to be able to smoothly and effectively exit from the current highly accommodative policy stance at the appropriate time.

“Our ability to pay interest on reserve balances held at the Federal Reserve Banks will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when needed, even if bank reserves remain high. Moreover, we have developed additional tools that will allow us to drain or immobilize bank reserves as needed to facilitate the smooth withdrawal of policy accommodation when conditions warrant. If necessary, we could also tighten policy by redeeming or selling securities.”

It really is not a question of if they have the tools to reverse course, but if they will pick the right time to do so. Do it too early and the economy turns south again; wait too long and inflation will eventually start to spike. Given the improved growth prospects for the economy, some are asking if the time is going to be sooner rather than later. I doubt it — we still have a VERY long way to go to get the economy back up to its potential (i.e. normal rates of unemployment and capacity utilization).

Things might be going in the right direction, but it is going to be a very long road. We might see the pace of the QE2 program slow down a bit, so the $600 billion total is finished in September of October rather than in June, but I think the program will be completed. As for the Fed Funds rate going up, that is unlikely to happen before 2012.

“As I am appearing before the Budget Committee, it is worth emphasizing that the Fed’s purchases of longer-term securities are not comparable to ordinary government spending. In executing these transactions, the Federal Reserve acquires financial assets, not goods and services; thus, these purchases do not add to the government’s deficit or debt.

“Ultimately, at the appropriate time, the Federal Reserve will normalize its balance sheet by selling these assets back into the market or by allowing them to run off. In the interim, the interest that the Federal Reserve earns from its securities holdings adds to the Fed’s remittances to the Treasury; in 2009 and 2010, those remittances totaled about $125 billion.”

He makes a good point here. There are those who want to add the $600 billion to the budget deficit, and they are conceptually mistaken in doing so. Fed remittances have been a pretty significant contributor to government revenues at a time when the government can use every dollar it can get its hands on to reduce the budget deficit. Again, the key question is, “When is the appropriate time?”

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