On November 21, 2002, Ben S. Bernanke, then a newly-appointed Governor of the Federal Reserve Board, gave a speech to the National Economists Club that made him famous. “Deflation: Making Sure ‘It’ Doesn’t Happen Here” was a speculation on how the Fed would attack the “purely hypothetical” danger of a prolonged and widespread decline in prices. It may seem counterintuitive that lower prices for most goods and services are a bad thing, but as Bernanke pointed out, “Deflation is in almost all cases a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.” In other words, deflation and economic recession—or worse—almost invariably go hand in hand.
In those happy, innocent days, Bernanke could reassure his audience that deflation was improbable for two reasons. The first was the strength of the US economy, and particularly, “the strength of our financial system…Our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.” That, of course, was then.
The second reason was the primary focus of Bernanke’s remarks. He asserted that the Federal Reserve System was “the second bulwark against deflation in the United States.” The Fed’s main tools for implementing monetary policy are setting a target interest rate for overnight borrowings between banks, called the fed funds rate, and then “enforcing that target by buying and selling securities in open capital markets.” Lowering the rate effectively reduces the cost of borrowings of all sorts and thereby stimulates consumer spending, the primary driver of our economy. But, there is an obvious, inescapable, and non-trivial difficulty: No matter what, interest rates cannot fall below 0%. Economists call this fact the “zero bound.” It’s kind of like the speed of light, an absolute limit. Once a central bank reduces the overnight borrowing rate to zero, it has exhausted what Bernanke called “its traditional means of stimulating aggregate demand.”
Bernanke then enumerated a number of potential weapons the Fed could use against deflation when and if the zero bound was reached. What made the speech so remarkable was that most of them had never been tried. Even more remarkable is that most of them, in one form or another, were tried in 2007 and 2008. As Bernanke suggested it might, the Fed has greatly expanded both the amount and variety of securities it buys in order to pump cash into the financial system. Between June 27, 2007, and September 30, 2009, securities on the Fed’s balance sheet increased from $791 billion to $1.59 trillion. None of the growth was Treasury securities, which, until the crisis was all the Fed bought. Instead, the Fed bought debt obligations of Fannie Mae, Freddie Mac and other Government-Sponsored Enterprises (GSEs). This spring the Fed announced that it would buy up to $1.25 trillion of mortgage-backed securities issued by the GSEs plus another $200 billion of direct GSE debt. Last month, it reiterated its intention to purchase the full amount by March 31, 2010.
Another option Bernanke posited in 2002 would be to offer fixed-term loans to banks, secured by a wide range of financial assets. During the financial crisis of 2007-08, the Fed did this, and more, offering loans not only to banks, but to money market funds, investment banks, and commercial paper issuers. Federal Reserve loans outstanding ballooned from zero on June 27, 2007, to almost $1.5 trillion at the end of 2008, though it has since fallen back to $348 billion. Cooperation with “fiscal authorities”—that is, the executive and legislative branches of government—was a third option. Bernanke suggested broad-based tax cuts and greatly increased government spending, which the team of Bernanke, Henry Paulson, and Tim Geithner were foremost in promoting at the end of the Bush presidency.
The one proposal Bernanke made that was not at all new was, ironically, the one that was not implemented. “As suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.” The phrase “as suggested by a number of studies” is essential in understanding Bernanke’s thinking. As David Wessel notes in his outstanding recent book, In Fed We Trust, Ben Bernanke was still, in 2002, a life-long academic. His specialty was the Great Depression. Bernanke believed that a series of misguided monetary policy decisions by the Fed was a primary cause of the Depression in the first place and of its persistence through the 1930s. According to Wessel this belief, “dominated Bernanke’s thinking throughout the Great Panic. He was determined that no future scholar would convict him of similar timidity or complacency in the face of a financial crisis.”
Bernanke’s determination to avoid blame was tempered by an equal determination, at least early in his chairmanship, to make his Fed more transparent and collegial than Alan Greenspan’s had been. While laudable, the results were unfortunate. Instead of acting “more preemptively and more aggressively” in the latter half of 2007, the Fed moved cautiously and, by early 2008, found itself seriously behind the needs of the financial markets and the economy for easier monetary policy. Part of the reason is that it’s much easier to recognize a crisis retrospectively than prospectively. But, the process was slowed by several Federal Reserve Bank Presidents, notably Richard Fisher of Dallas, Jeffrey Lacker of Richmond, and Charles Plosser of Philadelphia, who in speeches and Federal Open Market Committee (FOMC) meetings strongly opposed the initial easing of credit. Fisher, in particular, seemed slow on the uptake. Wessel describes him as man of “little prescience” perpetually “fretting” about inflation. As a result, the Fed had to play catch up, finally bringing the target overnight lending rate to 0-0.25% in December 2008. There it remains and is likely to do so “for an extended period” according to the latest FOMC statement.
But Fisher was not chastened; if anything, he has become a more hawkish inflation-fighter (now that no inflation exists to be fought). On September 29, he told an audience at Texas Christian University:
As to the long-term dangers of inflation…I remain ever vigilant. I have not hesitated in the past to vote against the majority of the FOMC when I felt they were being too accommodative, and I have been outspoken on the dangers of prolonged monetary stimulus in the future…I am not alone on this front. I have faith my colleagues on the Federal Open Market Committee will stand and deliver in a timely way. And I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that which we pursued monetary accommodation.
Them’s fightin’ words, and here’s why they’re scary. The basic economy is not improving. At best, we have flattened out to a lower level of economic activity. As Fisher himself admitted in the same speech quoted above, “While housing is showing some signs of having reached a bottom, we need to recognize that the sector is still on life support.” The employment picture is even gloomier. The official 9.8% unemployment rate is at a 26-year peak, and the rate for adult men, at 10.3%, is the highest since records began in 1948. The employment-to-population ratio fell to 58.8%, the lowest since women began to enter the workforce in large numbers. In December 2007, the ratio was 62.7%. The average time of unemployment is now a full six months and the median is 17 weeks. The “real” unemployment rate, which includes people forced to work part time instead of full time and those too discouraged to even look for work, rose to 17%. More than 26 million Americans are effectively out of work. A senior Goldman Sachs economist recently predicted that all 8.3 million jobs created between 2003 and 2007 will probably be lost before the economy recovers.
So here’s the Fed’s dilemma. If the economy remains weak for a prolonged period, as I expect it will, the Fed will have no choice but to maintain short-term interest rates at the zero bound. And, since it has already tried all the novel remedies Ben Bernanke proposed in 2002, the Fed probably is out of ammunition. But doing nothing for a long time is always an uncomfortable option. It’s just not the American way. The Fed will be pressured to do something, and that something most likely will be to raise interest rates to ward of future inflation. Bernanke will be reminded relentlessly of what is now considered Alan Greenspan’s catastrophic mistake for keeping the fed funds rate too low for too long in 2003 and 2004. Bernanke’s own recent statement that the recession is “probably” over could well come back to haunt him.
The first criticisms of accommodative monetary policy may come as early as October 28. That’s when the initial estimate of third quarter Gross Domestic Product—the total output of goods and services produced by labor and property located in the United States—will be released. After falling for four consecutive quarters and five out of the last six, an increase is virtually certain. But the first stage of any recovery is fragile and no matter how much the economy grows in the next few quarters, it will take years to make up what has been lost. No one can understand this better than Ben Bernanke, the student of the Great Depression.
The Federal Reserve, though differently constituted at the time, actually tightened credit by raising its discount rate—that is, the rate at which it lent directly to banks—twice in October 1931. It didn’t begin easing credit conditions until early 1932, but tightened again in March 1933. That tightening move was followed a month later by the start of an easing cycle that finally, in February 1934, brought the discount rate back to 1.50%, just where it had been in May 1931. The whole schizophrenic process was pointless and destructive. And here’s what nobody knew while the Fed was dithering. In 1933, after three years of double-digit declines, US GDP fell just 3.9%. It rose 17% in 1934, 11.1% in 1935, 14.3% in 1936, and 9.7% in 1937. Nobody knew it because GDP metrics were not compiled until after World War II. If the Fed had had GDP statistics in the 1930s, it wouldn’t have tightened credit in 1931, but it might well have in 1933. After another year or two of growth it almost certainly would have. This is the risk we face, that the Fed will be under increasingly intense pressure to restrict credit too soon. Premature tightening is a classic recipe for plunging a recovering economy back into recession. Sure, the economy had started growing again in the mid-1930s…but it was still the Great Depression.