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.

The Fed’s Exit Strategy

In an editorial in the Wall Street Journal on July 21, 2009, Ben Bernanke, the chairman of the Board of Governors of the Federal Reserve System, explained "The Fed's Exit Strategy":

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid. However, reserves likely would remain quite high for several years unless additional policies are undertaken.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

—Mr. Bernanke is chairman of the Federal Reserve.

The lucky duckies who pay no income taxes - another look

According to the January 20, 2003 Wall Street Journal editorial "Lucky Duckies Again: Look at who won't pay taxes under Bush's plan":

As you may have noticed, the critics of President Bush's new tax cut package claim it is a sop to the rich. This charge makes us wonder if they've even read the plan. The truth is that the Bush proposals would make the tax code more progressive, not less. And this isn't altogether a good thing.

The soak-the-rich facts, if any journalists cared to look, are contained in the income distribution tables on the plan compiled by the Treasury Department. Looking at the impact for 2003, Treasury finds that the average reduction in income taxes is a touch more than 12%. But for those who make less than $30,000 the average reduction is about 17%, while for those who earn more than $100,000 it is 11.4% or less. (See the table below.)

There's even better news for modern Robin Hoods. Because the percentage reduction for families with incomes under $50,000 is greater under the Bush plan, those families would pay a smaller share of the total income tax than they do under current law.

Tax Cuts for the Poor
Lower earners would get a larger percentage income tax cut on average under the Bush plan.
Income
Percentage reduction
0-$30,000
17.0%
30-40,000
20.1%
40-50,000
14.5%
50-75,000
11.4%
75-100,000
13%
100-200,000
11.4%
200,000-plus
11.2%
Total
12.3%
Families with incomes over $100,000 would end up paying a larger share of the total income tax. These families would pay 73% of all federal income taxes. Not to put too fine a point on this income redistribution, but taxpayers with incomes over $200,000 could expect on average to pay about $99,000 in taxes under Mr. Bush's plan.


How could this happen? Mr. Bush would relieve 3.8 million lower-income taxpayers from paying any income taxes. The chief tax remover comes from his proposal to accelerate the increase in the child credit to $1,000 from $600, bumping a touch more than three million taxpayers right off the rolls.

No doubt the Bush team proposed this tilt toward lower income taxpayers to mute the class-warrior critics, not that we've noticed any lower decibel level. But one certain consequence is that the plan exacerbates the growing problem of a bifurcated tax system.

We raised this issue several weeks ago, pointing out that the unceasing addition of exemptions, deductions and credits to the tax code was shrinking the tax-paying base. And, as more lower-income people saw tax liabilities fall to zero, more upper-income people shouldered a larger part of the tax burden. We did not, by the way, suggest that lower income people should pay higher taxes. We even went out of our way to flog our favorite horse that everybody should pay less in taxes.

We are merely pointing out the (apparently heretical) truth that the current tax system is very skewed against upper-income Americans. According to IRS data from 2000, the top 5% of tax filers paid more than 50% of total income tax revenue, and the top half of tax filers were responsible for almost all revenue--96% of the total take. This burden on the upper-income holds even when the payroll tax is included in overall distribution tables. (The payroll tax includes the regressive Social Security levy and the 1.45% Medicare tax that applies to every dollar of income.)

The Congressional Budget Office has looked at the distributive impact of various taxes for 1997. The income-tax share of the lowest-income family quintile (the bottom 20%) was negative 1.2% and the share of the highest family quintile was 73.3%. The difference in payroll-tax share was somewhat less dramatic at 3.9% for the lowest quintile and 40.6% for the highest. But when all federal taxes were thrown together, the share of the lowest quintile was 1.6%, while the share of the highest quintile was 60.2%. Karl Marx, call your office.



This super-progressivity comes from two sources: the system of higher marginal-rate brackets for higher income households, and the exclusion of lower income households from any income-tax liability. In 2000, of 129.4 million tax returns filed, about 32 million paid no taxes. Most of these lucky duckies, as we have called them (to some amusing consternation), benefit from tax exemptions, deductions and credits that violate the concept of horizontal tax equity--the notion that people with identical incomes should pay the same amount in taxes.

For instance, the folks at the Tax Foundation have looked at how two single moms--each earning $30,000 a year--would fare under the Bush plan. In 2003, the single mom with one child would pay income tax of $1,028; the mom with two children would not only pay no taxes, she'd also receive a check from the federal government, under the earned income tax credit, for $680. Compared to the single mom who must pay taxes, the single mom who does not is, well, a lucky ducky.

The broader point is that whatever Mr. Bush's tax proposal does for economic growth (and we think it'd do a lot), it gives more proportional benefit to lower-income households. The class warriors should be thrilled.

Also see the editorial "The Non-Taxpaying Class: Those lucky duckies!" which originally appeared in The Wall Street Journal on November 20, 2002.

The lucky duckies who pay no income taxes

According to the November 20, 2002 Wall Street Journal editorial "The Non-Taxpaying Class: Those lucky duckies":

The stars look to be in perfect alignment for tax relief. With a GOP majority in both houses of Congress, the Bush Administration is making eager and energetic noises, and the economy is in what Fed Chairman Greenspan calls a soft spot.

But as the Republicans construct their tax plan, there is a large and under-appreciated fact they would do well to keep in mind. Over the past decade or so, fewer and fewer Americans have been paying income taxes and still fewer have been paying a significant percentage of income in taxes. While we would opt for a perfect world in which everybody paid far less in taxes, our increasingly two-tiered tax system is undermining the political consensus for cutting taxes at all.

Even the barest of glances at tax data reveal a system that is steeply progressive. Tax revenue has been increasingly squeezed out of top earners. According to the most recent data, from 1999, the richest--with income above half a million dollars--constituted 0.5% of taxpayers but accounted for 28% of total tax revenue. Simply put, a tiny group of people (553,380) were responsible for more than one-quarter of the income tax take of $877 billion.

...

Well, maybe you're saying--so what? They can afford it. Then take a look at those who aren't Richie Rich. The most recent data from the IRS, in 2000, show that the top 5% coughed up more than half of total tax revenue. Specifically, we are talking about folks with adjusted gross incomes of $128,336 and higher being responsible for 56% of the tax take. Eyebrows raised? There's more. The top 50% of taxpayers accounted for almost all income tax revenue--96% of the total take.

These numbers are more arresting when compared with the situation 14 years earlier. In 1986, the top 1% paid 26% of revenue, the top 5% was responsible for 42% and the top half contributed 93%. And what about the bottom half of taxpayers? They accounted for 7% of the total in 1986 but only 4% in 2000.

This skewed reality is the result of a growing number of absolutely legal escape hatches. Consider what happens to those in the lowest bracket. Say a person earns $12,000. After subtracting the personal exemption, the standard deduction and assuming no tax credits, then applying the 10% rate of the lowest bracket, the person ends up paying a little less than 4% of income in taxes. It ain't peanuts, but not enough to get his or her blood boiling with tax rage.

Of course, lower-income workers are on the hook for the payroll tax--but a sizable group slip free from even that net tax liability via the refundable earned income tax credit. ("Refundable" means that even if your net income tax liability is zero, the government still writes you a check.)

These numbers represent only people who have a positive adjusted gross income. In 1999, there were 127 million tax filers, 94.5 million of whom showed an income tax liability. That is, 26% had no liability at all. The actual number of people filing without paying comes to 16 million (after subtracting those getting earned income tax credits and thus, presumably, still somewhat sensitive to tax rates). So almost 13% of all workers have no tax liability and so are indifferent to income tax rates. And that doesn't include another 16.5 million who have some income but don't file at all.

Who are these lucky duckies? They are the beneficiaries of tax policies that have expanded the personal exemption and standard deduction and targeted certain voter groups by introducing a welter of tax credits for things like child care and education. When these escape hatches are figured against income, the result is either a zero liability or a liability that represents a tiny percentage of income. The 1986 tax reform, for example, with its giant increase in the personal exemption and standard deduction, took six to seven million people off the tax rolls.

...

This complicated system of progressivity and targeted rewards is creating a nation of two different tax-paying classes: those who pay a lot and those who pay very little. And as fewer and fewer people are responsible for paying more and more of all taxes, the constituency for tax cutting, much less for tax reform, is eroding. Workers who pay little or no taxes can hardly be expected to care about tax relief for everybody else. They are also that much more detached from recognizing the costs of government.

All of which suggests that the last thing the White House should do now is come up with more exemptions, deductions and credits that will shrink the tax-paying population even further.