Bernanke Deciphered

Published April 21, 2011

In March, Fed Chairman Ben Bernanke testified before the House Committee on Banking. I find his testimony extremely disturbing. In the exchange below, I have placed the Chairman’s comments first, then provide my interpretation of what those comments should have been. The following are direct quotes from his testimony.

Bernanke:  FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years. Measures of medium- and long-term inflation compensation derived from inflation-indexed Treasury bonds appear broadly consistent with these forecasts.
More broadly, the increases in commodity prices in recent months have largely reflected rising global demand for raw materials, particularly in some fast-growing emerging market economies, coupled with constraints on global supply in some cases. Commodity prices have risen significantly in terms of all major currencies, suggesting that changes in the foreign exchange value of the dollar are unlikely to have been an important driver of the increases seen in recent months. 

Deciphered: The Fed doesn’t recognize a lag between its creation of money and an increase in current dollar spending. Instead we prefer to look at inflation over the past year as a guide to whether we create too much money. Just because this means we have often reacted two to three years too late in responding to any inflation threat doesn’t bother us at all.  

Bernanke: That said, sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability, particularly if they were to cause inflation expectations to become less well anchored. We will continue to monitor these developments closely and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability. 

Deciphered: In any event, the Fed’s creation of money doesn’t have anything to do with inflation. Everyone else is to blame. If oil or other commodities continue to remain in short supply, the public’s expectations of future inflation could increase. This would create problems.
Bernanke: … the Federal Reserve would normally ease monetary policy by reducing the target for its short-term policy interest rate, the federal funds rate. However, the target range for the federal funds rate has been near zero since December 2008, and the Federal Reserve has indicated that economic conditions are likely to warrant an exceptionally low target rate for an extended period. Consequently, another means of providing monetary accommodation has been necessary since that time. In particular, over the past two years the Federal Reserve has eased monetary conditions by purchasing longer-term Treasury securities, agency debt, and agency mortgage-backed securities (MBS) on the open market. The largest program of purchases, which lasted from December 2008 through March 2010, appears to have contributed to an improvement in financial conditions and a strengthening of the recovery.

Deciphered: We at the Fed don’t believe we increase spending by creating more bank reserves or more money. Instead, we believe interest rates are the key determinant of monetary policy. However, since we have driven short-term rates to zero we now have had to wing it by trying new things.  
Bernanke: A wide range of market indicators supports the view that the Federal Reserve’s recent actions have been effective. For example, since August, when we announced our policy of reinvesting principal payments on agency debt and agency MBS and indicated that we were considering more securities purchases, equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen to historically more normal levels. Yields on 5- to 10-year nominal Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases.

Deciphered: As I mentioned earlier, just because the Fed directly controls the amount of bank reserves, and hence liquidity, doesn’t mean we talk about those things. We never comment about what we at the Fed are responsible for. This is because things other than monetary policy are responsible for all problems that occur. Our job at the Fed is to wait and see what problems might be occurring and then alter interest rates or expectations to correct those problems. We have done a marvelous job. Every improvement you see in the economy is due to our announcements regarding monetary policy. These announcements alter expectations in a positive way. When interest rates fall in response to the stated policy, it stimulates the economy. When interest rates rise, it’s because the economy has been stimulated. 
I have just one closing comment. Please do not look back at the amount of bank reserves that we at the Fed create. Even though we have complete control over these reserves, it would not be constructive to have the public realize that we had increased reserves substantially prior to the speculative boom in the middle of the past decade. It would be outright destructive for the public to realize that we then spent four years reducing the amount of bank reserves and liquidity prior to the financial collapse.

After all, if the public realized how poorly we have conducted monetary policy, it could have a negative impact on their expectations for the future. Of course, if that were to happen, we at the Fed would solve that problem.

Robert Genetski ([email protected]) is an economist and author of several books. His latest is Classical Economic Principles, released this spring.