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Bernanke’s Confidence Game

Wednesday, February 24, 2010

The Federal Reserve chairman bets that mastering tactics will restore faith in an otherwise-undefined future. It’s a difficult trick to pull off.

Federal Reserve Chairman Ben Bernanke’s congressional testimony this week will likely provide striking confirmation of how much attitudes toward economic policy making have shifted in recent months. Even as the unemployment rate hovers near 10 percent and measured consumer prices fall, Bernanke and his Senate and House interlocutors will spend most of their time talking about how and when the Fed will exit from its current stance of unusual accommodation.

Public officials do not often look past the near-term state of the economy to the longer term, especially when millions of voters are wastefully unemployed (and almost as many underemployed). It would be reassuring if this focus represented a newfound embrace of rectitude. Rather, it betrays the recognition that investor mistrust constrains policy flexibility on several fronts.

Public officials do not often look past the near-term state of the economy to the longer term, especially when millions of voters are wastefully unemployed.

The public is rightfully suspicious of a Fed that embraces using its balance sheet to protect private firms from market outcomes and routinely resists articulating its inflation goal. Meanwhile, the fiscal accounts of our nation are a mess, and politicians seem unwilling or incapable of cleaning them up. Both failures cloud our economy's prospects and make it difficult to predict fundamental asset values beyond the near term. These are not features conducive to investor confidence, ongoing commitment to markets, or longer-run stability in the value of the currency.

Our appointed and elected leaders treat such concern as a pesky inconvenience. With regard to both monetary and fiscal policies, officials focus on what they will do, not where they want to lead us. This shows the value of the old distinction between tactics, or how to deploy resources in a battle, and strategy, or how to plan to win the war.

The public is rightfully suspicious of a Fed that embraces using its balance sheet to protect private firms from market outcomes.

Thus, Bernanke will talk about reverse repurchase agreements and interest on excess reserves as congressional committee members nod in agreement. Mastery over tactics, the bet runs, will restore faith in an otherwise undefined future. It is a difficult trick, this confidence game. The Fed will provide enough detail about its tactical exit from its unusual policy accommodation to allay concerns, but not so many specifics as to lead market participants to believe it intends to head for the exit soon.

Lost in this thicket of expertise will be important public policy questions basic enough to be assigned as homework in a high-school journalism class.

When will the Fed begin to raise the short-term market interest rate? The Fed has the dual responsibility of fostering employment and price stability. As of now, the Fed continues to forecast substantial and lingering unemployment that puts downward pressure on inflation. Until policy makers can produce a forecast that gives a reason to tighten, they will not tighten. That outlook is not likely to change until late this year.

What is the Fed's long-term plan? No one who knows is telling (that is, if anyone knows).

How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. Over the past one and a half years, the Fed has piled on securities with long maturities and exposed itself to credit risk. If it sold those assets, it would post considerable losses, deadly to the institution's already fragile reputation in the current political climate. Instead, the Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.) This matters because two slots on the board are currently open, giving the White House an important opportunity to shape monetary policy through future nominations. Indeed, given natural turnover among governors, President Obama will probably be able to appoint a majority of the board in a single term of office.

Without doubt, Federal Reserve Chairman Ben Bernanke is among the best and brightest of officialdom.

What is the Fed's long-term plan? No one who knows is telling (that is, if anyone knows). The Fed has resisted specifying a numeric target for inflation or the weight it puts on unemployment.

Why is the Fed tolerating a recession-level unemployment rate? The Fed believes it has no choice because the market's faith in its longer-run intentions is fragile. Talk of tactics will not lift that cloud of suspicion. An alternative strategy is to anchor inflation expectations by spelling out a longer-term inflation goal and nearer-term sensitivity to unemployment, and to work with the Congress to harden protections for monetary policy. This should include shedding the Fed's unhelpful responsibilities for bank supervision and consumer protection and limiting its lending authority to prevent future interventionism.

Without doubt, Bernanke is among the best and brightest of officialdom. But in another context, a succession of storied defense secretaries over the decades pressed the superiority of U.S. tactics as the means to victory. In retrospect, there is greater value in knowing the journey's destination than its path.

Vincent Reinhart is a resident scholar at the American Enterprise Institute.

FURTHER READING: Reinhart has recently commented on “The Peril of Anointing a Favored Financial Few,” “The Crack-up” of administration financial policy, and the “Pluck of the Irish.” He has unraveled “The Perfect Financial Storm Fallacy” and explained “Simple Rules for a Complex Financial World.” He made “The Case for Simpler Financial Regulation” to Philadelphia’s Federal Reserve Bank, and discussed “Dealing with Crises in a Globalized World” before the Federal Reserve Bank of Chicago.

Image by Darren Wamboldt/Bergman Group.

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