Bernanke’s Assurances

The "Bernanke’s Assurances" article in the Wall Street Journal on July 22, 2009 evaluated Fed chairman Ben Bernanke's testimony before Congress:

Federal Reserve Chairman Ben Bernanke took his “exit strategy” on the road yesterday, promising that he knows how to withdraw excess liquidity from the financial system in time to avoid a new inflation or another asset bubble. We’re glad to hear it, but then few have doubted that the Fed knows how to exit. The issue is whether he and his fellow Governors have the nerve to do it.

In an op-ed for us and in his testimony on Capitol Hill, Mr. Bernanke stressed the Fed’s technical ability to withdraw the liquidity it has injected to stem last year’s financial panic. For example, it can raise the interest rate it pays on the balances held by banks at the Fed, which would induce the banks to keep larger balances and thus remove money from the economy. This is an untraditional mechanism for monetary policy, but we’ve been in similar uncharted territory for at least 18 months. The Fed’s monetary gnomes are certainly up to the technical task.

Mr. Bernanke was far less reassuring on the more potent questions of whether and when the Fed will reduce its balance sheet. In particular, the Fed chief reiterated that it’s too early to start tightening and that the Fed will keep its current policy of near-zero interest rates for “an extended period.” So how long is extended? Mr. Bernanke didn’t say, and we are all supposed to assume that he’ll know the right moment when he sees it.

As readers of these columns know, we’ve been here before—specifically, in late 2003 when Mr. Bernanke was a Governor at Alan Greenspan’s Fed. Despite an expansion that was already well under way, Mr. Bernanke argued at the time that the Fed needed to keep the fed funds rate at 1% for an “extended period” in order to reduce unemployment. Thus began the commodity and credit bubbles that brought us to our current pass. Mr. Bernanke has never acknowledged that blunder, though a couple of his more reflective Fed colleagues have.

This time the Fed’s political and policy dilemmas will be far more acute. The Fed’s current policy is the easiest in its history and continues even as the financial panic has subsided and the big banks are again making money. On the other hand, the jobless rate is 9.5% and likely to climb further even once the recovery begins. With Washington creating policy uncertainty over the future of tax rates, health care, energy prices, antitrust and so much else, businesses will be slow to rehire, if they do at all.

Congress and the White House want the Fed to stay easy as long as unemployment stays high. But if the Fed does so, it will run the risk of acting too late, well after inflation expectations have begun to build. Such expectations aren’t apparent now, with the economy still on the mend. But signs to watch include commodity prices, long-term bond rates, and especially the dollar. The problem is that Mr. Bernanke has long dismissed both the value of the dollar and commodity prices as guides to monetary policy. Like the Fed staff, he focuses on unemployment and the “output gap,” which is the difference between actual and potential economic growth. Both are lagging economic indicators, which is why the Fed so frequently is behind the curve with its monetary decisions.

All of this is compounded by Mr. Bernanke’s personal “no-exit” strategy, by which we mean his campaign to be reappointed to a second term as Fed Chairman. His current term expires early next year, and Mr. Obama will soon have to decide whether to choose his own chairman or give Mr. Bernanke another four years. Mr. Bernanke has been in full campaign mode for months, and auditions for Fed appointments rarely include raising interest rates.

All of which makes Mr. Bernanke’s assurances yesterday nice to hear but less than reassuring. We’ll believe them when we see the Fed begin to tighten despite political objections from Capitol Hill and the White House.