AS a central banker 25 years ago, I used to attend the Jackson Hole, Wyoming annual monetary symposium organised by the Kansas City Fed.
Those days, the tone used to be unusually policy heavy. The meetings tended to focus on loftier academic research, including new ideas in practical monetary matters and empirical work in rendering monetary policy more “scientific”.
As years passed, the research became increasingly mathematical. More recently, this symposium assumed a high profile, featuring prominent names in monetary policy formulation, application and forecasting.
Always, the centre of attraction is the Federal Reserve chairman’s keynote address. This year’s meeting in late August didn’t disappoint.
Not unlike the previous two years, Ben Bernanke’s statement was anxiously awaited. This time for indications on the economic outlook in the face of anaemic US activity, and the direction monetary policy would take to get the US economy off what Larry Summers labelled “a statistical recovery and a human recession.”
Keenly awaited are views of critics on both sides of the economic divide. As Bernanke spoke, more lukewarm news were released – US hiring and manufacturing output cooled in August, indicating companies were scaling back as US recovery showed signs of stumbling.
Indications are private payrolls rose by 47,000 (71,000 in July), while unemployment rose to 9.6%. Others showed households purchases stagnating and services (largest part of the economy) decelerated.
The official line
Bernanke confirmed what many (myself included) had predicted – “the country’s recovery has softened more than expected,” and the Fed stood ready to take further steps (if needed) to spur the slowing economy, including resuming buying larger amounts of long-term debt. Nothing we don’t already know.
The latest sign of more trouble came when the Department of Commerce revised second quarter gross domestic product (GDP) growth downwards to 1.6% (from 2.4% previously).
The US needs growth of 2.5% just to keep unemployment stable. Bernanke painted a sober picture that growth had been “too slow” and unemployment “too high”.
But he tried to reassure that “preconditions for growth in 2011 are in place”, with handoff from fiscal stimulus and inventory restocking (for consumer spending and business investment), appearing “to be under way” and that risk of “undesirable rise in inflation and of significant growth in inflation seems low”. This is not unexpected.
The Fed badly needs to show its relentlessness in preventing a double-dip deflation. He pledged to boost monetary stimulus should the economy continue to deteriorate. However, he avoided comment on the appropriate stance of fiscal policy in the circumstance.
Incoming data confirmed the US was moving at a pace lower than most of the Fed’s Open Market Committee members projected earlier.
Back to back quarters of growth below 2% are likely to put more downward pressure on inflation, which is already lower than its desired targets.
It is obvious Bernanke will be vigilant against driving the economy to Japan-like deflation. The Fed definitely likes to see faster growth than what most private economists perceived for the rest of this year.
I wrote in this column “Threat of a double-dip deflation” (Aug 28) that Wall Street is taking the possibility of a double-dip deflation seriously enough to act on it. Goldman Sachs puts the likelihood at 25-30%, a substantial risk, but adds that it’s possibly unlikely.
As Bernanke spoke, his counterparts in the UK and the European Central Bank (ECB) echo the same optimism, although somewhat more guarded.
The Bank of England admitted more monetary stimulus may be required to sustain the fragile recovery as US activity cools and debt crisis threatens the euro zone, while at home deleveraging remains incomplete and considerable spare capacity has yet to be worked-off.
It admitted monetary policy appears “too weak and unreliable to moderate credit and asset price boom without inflicting unacceptable collateral damage on activity.”
The bank is examining new methods to do the job better, including closer co-ordination between monetary policy and macro-prudential actions to avoid “pull-me-push-you” results.
The ECB sees Europe being on the brink of a self-sustaining recovery at a time when fiscal consolidation is placed top of the political agenda: “There is not much concern for renewed recession but performance will be somewhat weaker going forward.”
President Jean-Claude Trichet urged governments to think long-term to reassure markets that an orderly transition from high debt and the recent economic fallout will take place without compromising growth.
The challenge years ahead are to “ensure that they do not turn into another lost decade.” This long-term approach makes a lot of sense. In the meantime, it would be “wise” to keep its policy of making available unlimited liquidity until year-end.
Uncomfortable monetary math
Worries about double-dip deflation abound. Outside the Fed, there is growing fear on risks of continuing Fed quantitative easing (QE) outweighing its benefits.
Prof A. Blinder of Princeton thinks “it has low returns period and maybe diminishing returns to scale.” This is because what’s accomplished came from the “announcement effect” on market expectations. Little to do with the purchases of securities themselves.
It has been estimated that US$100bil of Treasury purchases may lead to only 0.1% age point fall in long-term rates.
What would it take to get consumers spending again?
At the beginning of the crisis, Goldman Sachs estimated QE had to inject US$4-US$5 trillion worth of credit to do the job.
But this policy plus Congress’ US$800bil stimulus have not gone the way it was intended. Even if it succeeded in preventing a worse-off outcome, it didn’t last. The economy is slipping again.
The Fed’s balance sheet had bloated to US$2.3 trillion from only US$850mil pre-crisis. What’s the future impact when the Fed finally unwinds to exit?
Given the present mood of the US Congress, another major fiscal stimulus package looks unlikely. That leaves QE2 (mark two version) to do the job.
Central banks in US, Europe and Japan have already slashed interest rates to near zero. Dare they move to negative interest rates? At this time, this is too much to expect. Which raises the question: Is fiscal policy now really impotent?
Empirical evidence confirms fiscal policy (especially when they act in concert with monetary policy) can have as strong an impact on economic activity and inflation as do monetary actions.
I sense a breath of fresh air in Prof E. Leeper’s (Indiana University) suggestion that fiscal “alchemy” must mimic monetary science to provide a new way out of the conundrum. It is true modern monetary research and practical policy making are sufficiently blended to make monetary policy “scientific.”
Similarly, tax and budget policies need the same independence of action as monetary policy to expand the nation’s repertoire of policy tools to tackle the complex dynamic problems facing the world today.
To cope with looming stresses which demographic shifts are exerting on ever rising government spending on pension and health care programmes, fiscal policy needs to be freed from politics.
US politicians have debated to death whether to raise taxes or cut benefits to social security and medicare retiree pension and healthcare programmes.
The problems raise new challenges as the baby boom generation retires. Central bankers need to pay heed to taxation and budgeting in the future as the stresses from such financial obligations intensify.
Just as there is an understanding central bank decisions should be made independently without political interference, financial markets need to be able to look forward confidently to expect fiscal policy to be formulated in response to any slowdown in economic growth or fall in inflation.
Two other studies were debated. Carmen and Vincent Reinhart (University of Maryland) examined severe dislocations over the past 75 years, including 15 crises since WWII as well as the Great Depression and 1973 oil shock.
Their results warned the future is likely to bring only hard choices, and included:
·GDP growth tends to be much lower during the decade following the crises, and unemployment much higher indeed in 10 of the 15 episodes (unemployment never fall back to pre-crises level);
·House prices took years to recover and deleveraging debt is often delayed and protracted;
·Big changes in long-term macroeconomic indicators take place well after the crisis is over;
·History shows a failure to provide sufficient stimulus (slow growth becomes self-fulfilling); and
·Economic contraction (and slow recovery) can dent aggregate supply – indeed, political quick fix often impairs, rather than improve.
Lessons point towards more prudent post-crisis policy to be alert of threats to supply and demand, not just demand; beware of impatience for the worst to have past as the dust settles – but the shock is more likely to be “deep and persistent, not temporary.”
Bernanke’s optimism at attempting to restore employment to pre-crisis levels may prove premature, if history lessons are to be learnt.
The other study by J. Stock (Harvard) and W. Watson (Princeton) discusses inflation which has fallen so sharply, feeding new fears the economy is at risk of deflation.
This cycle still has room to fall in 2011. So much so Bernanke reiterated the Fed would “strongly resist deviations from price stability in the downward direction.”
Stock and Watson found US recessions to be associated with falling inflation, except during the jobless recovery from the 2001 recession in 2004 when inflation rose. This exception remains a mystery.
In the good old days, Jackson Hole was a cowboy town with saloons and gunfights. Today, it’s a holiday resort; mock shoot-outs are only staged for summer tourists.
The Fed’s tepid pledge to do all it can to shoot down double-dip deflation sounded rather desperate. After all, its remaining arsenal might not do the job – more aggressive buying of Treasures; lower rates banks earn on excessive reserves; raising inflation targets.
Their collateral damage is of increasing concern. That’s why Bernanke ruled out the third more radical step. But what’s worrying the markets is when push-comes-to-shove, Bernanke could be shooting blanks in the absence of supportive fiscal policy moves.
Lost confidence can be self-fulfilling. History does not appear to be on his side.
>Former banker Dr Lin is a Harvard-educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome at email@example.com.