In preparation for Chairman Bernanke’s press conference on Wednesday, my friends at FT Alphaville asked me to respond to a series of questions on US monetary policy – first predicting what the Fed chairman will say, and then commenting on what he should say. During the press conference itself, I will be participating in a live blog session over at Alphaville.
Here is the Q+A.
1. What is your exit strategy from QE2?
My Prediction of Bernanke’s Response : “Today’s FOMC Statement announced that the $600 billion program of purchases of treasury securities by the Federal Reserve will not be extended beyond the end of June. However, the statement also said that the Fed will not reduce the size of its balance sheet in the immediate future, but will instead re-invest the principal payments from securities which reach redemption into new treasury securities. In addition, the statement said that the committee continues to anticipate that economic conditions including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. I am confident that the Federal Reserve has all of the tools necessary to raise short term interest rates when it chooses to do so, even if the central bank reserves held by the banking system remain at or near present levels. We will continue to set policy so as to achieve our mandate of achieving maximum employment consistent with price stability. The committee will continue to review all incoming evidence in the light of its mandate, and will adjust its balance sheet and the level of short term interest rates accordingly.”
Comments: Bernanke’s predicted answer would mean that the Fed is no longer actively easing monetary policy by increasing the size of its balance sheet, but nor is it ready to embark on any tightening in US monetary policy at present. This seems the right course of action. The economy has been growing at close to trend in the last two quarters, and core inflation remains below target. The FOMC does not need to commit itself in advance to a program which would reduce the balance sheet. This should be reviewed – in both directions – according to economic conditions at the time. I do not believe that the cessation of new bond purchases will, in itself, have a dramatic effect on the financial markets. A net shrinkage of the balance sheet, and/or a change in the “extended period” language, would be another matter entirely.
2. What’s your view on setting a target for the price level rather than for the inflation rate, as two of your co-doves have advocated?
Bernanke: “The FOMC as a whole sees little merit in these proposals under current conditions. Core inflation is running slightly below the level which we judge to be consistent with stable prices, but the threat of deflation has been reduced to negligible proportions. Price level targets might have a useful role in deflationary conditions, but they would not be relevant in current conditions.”
Comments: Price level targets would essentially force the Fed to catch-up with past mistakes when it misses its inflation targets. Therefore, if it continues to miss its inflation target on the low side, it would need to adopt increasingly expansionary policy, and vice versa. This could become quite destabilizing in both directions. I would prefer to stick to the current way in which the Fed interprets its “stable prices” mandate. The inflation “target” is now quite well understood, and helps to stabilize price inflation expectations. Changing the target would cause a lot of confusion.
3. You’ve said many times that you think the impact of commodity price rises on overall inflation will be “transitory”, but that’s contingent upon commodity prices rises actually moderating. Given that emerging market demand is still strong, that the possibility for further shocks still exists, and that the commodities sector has become highly financialised and sensitive to unanticipated events, how can you be so sure that they will?
Bernanke: “The FOMC still believes that the impact of higher commodity prices on US inflation will be temporary and relatively modest. Core inflation is a better guide to monetary policy than headline inflation, because it contains more information about the future course of overall inflation one or two years ahead. The FOMC will continue to monitor the outcome for inflation and especially for inflation expectations and will respond as necessary to support the ongoing recovery in the context, over time, of price stability.”
Comments: Mr Bernanke is on weak ground when he argues that the recent rise in commodity prices has nothing to do with the Fed’s policy of quantitative easing, while also claiming that QE2 has weakened the dollar and raised equity prices. He can’t have it both ways! However, he is on stronger ground in postponing any policy response to the current rise in headline inflation. This has clearly reduced economic growth in the past few months, and will continue to do so. However, if price expectations start to rise – as they have done to a moderate extent recently – then there will be no hiding place for the Fed. Their credibility would not survive if they permit that to happen without raising rates.
4. Why won’t you disclose whether any investors who used Talf lost money on their investments and turned over their collateral?
Bernanke: “The Fed has complied with all requirements to disclose information about the transactions conducted under the Talf and will continue to do so.”
Comments: I am not sure why he is so sensitive about this, since the Fed has emerged unscathed from the 21,000 transactions which have been published so far. Publish and be praised!
5. Is the Fed buying put options on TSYs?
Bernanke: “There is no risk of default on the Fed’s holdings of Treasuries, and the Fed has no need to hedge its balance sheet against short term variations in the value of securities on its balance sheet.”
Comments: The Fed does not mark-to-market the value of its securities holdings in the same way in which an investment bank does so. Nor does it face any danger of a liquidity problem if its net worth were ever to head towards negative territory. Therefore the need to hedge itself against losses on its securities portfolio does not arise.
6. How do you keep crumbs out of your beard?
Bernanke: Pass the cookies and I’ll show you.
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