Friday, July 15, 2011

The Other Four Important Insights From Bernanke's Testimony

Chairman Bernanke's testimony before Congress this week generated much attention because he mentioned the Fed remained open to further monetary easing.  Many observers interpreted this statement as Bernanke opening the door for QE3.  Though this was the big news from Bernanke's visit to Congress, there were four other important insights in his testimony worth mentioning too. 

First, Bernanke affirmed his new-found love for the portfolio channel of monetary policy.  The idea behind this channel is that through its purchases of longer-term securities the Fed can cause investor's to rebalance their portfolios toward riskier but higher yielding assets like stocks and capital.  Eventually, these asset prices would increase and their yields drop providing a boost to consumption and investment spending. Here is Bernanke:
The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program--like more conventional monetary policy--has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy.
Another way of saying this that is that Fed's asset purchasing program is simply moving down the list of is going from buying treasury bills to buying treasury notes and bonds--whose yields also affect money demand.  When the zero bound on short-term interest rates is hit and money demand still remains elevated it is time to start lowering yields on other longer-term securities until money demand drops and nominal spending is fully restored. (See Edward Nelson for a more on this channel and see here for evidence that money demand still remains highly elevated.)  

I am glad to see Bernanke get behind the portfolio channel, though the lack of a robust recovery means this channel's potential hasn't been fully utilized.  An important part of this channel is shaping the expected path of nominal spending and interest rates so that investors start rebalancing their portfolios on their own.  The Fed shouldn't have to do the heavy lifting if it sets expectations correctly. But since the Fed has yet to commit to a level target this has not happened.  

Second, Bernanke implicitly acknowledges that interest rates would be low even in the absence of the Fed.  This is an important point that many commentators miss.  Interest rates are low now mainly because the economy is weak, not because of Fed policy.  The weak economy has pushed the equilibrium or neutral interest rate down and the Fed at best has only marginally lowered it. Again, here is Bernanke:

Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points. 
To put this in perspective, the 10-year treasury yield reached a low of about 2.5% in October 2010.  Add the upper-end estimate of 30 basis point to this and the 10-year yield is still only 2.8%, a low number relative to its value over the past decade. Interest rates will rise once the economy begins to really recover, not before.  What is frustrating for me is to see many otherwise thoughtful folks, including some Fed officials, failing to understand this point and calling for higher interest rates. This has the causality completely backwards.  At least the folks at the Swedish central bank get it right.

Third, Bernanke acknowledges the Fed still has plenty of ammunition in its monetary arsenal.  Bernanke, therefore, disagrees with the David Brooks of the world who say there is no magic lever or the Richard Koos of the world who say a central bank can do nothing in a balance sheet recession. Here is Bernanke on what else the Fed can do:
Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.
So the Fed can better shape expectations (which would happen if the Fed would just set a level target!), buy up more longer-term securities, and lower the interest payment on excess reserves. Of these options, I see the first as being the most effective.  In fact, the first option is more or less what Bernanke told Japan to do in the 1990s.  If it is good for Japan, why not the United States?

Fourth, Bernanke reiterated the Fed's desire to slouch on the job and ignore the aggregate demand shortfall.  Okay, he did not exactly say that, but it was implied by the fact the Fed is doing nothing despite the ongoing elevated demand for money and money-like assets.  Bernanke, himself, has recently said that monetary policy can be passively tightened by doing nothing. (He was referring to the Fed's balance sheet passively shrinking by not reinvesting its mortgage earnings.)  As Ryan Avent notes, it is amazing to see Bernanke list all the things  the Fed could still do to help the economy, but chose not to act.  


  1. "As Ryan Avent notes, it is amazing to see Bernanke list all the things it could still do to help the economy, but chose not to act".
    That, to me, is the real "conundrum". And I think it´s even worse because time and again he only shows worry about deflation!

  2. David,
    If it is true that interest rates are low because the economy is weak, are you saying that rates would be at current levels without QE2? I don't disagree with your premise that rates are depressed as a result of weak demand. The question is, are other factors contributing to excess demand for money. Paying interest on excess reserves, readily comes to mind. Additionally, it appears that a paradox has occurred: With rates this low, coupled with weak demand there isn't enough risk premium to entice lenders to free up capital.(Which is why some are calling for higher rates of interest.) Furthermore, with signals on the fiscal side from Congress that will certainly slow the economy further, excess demand is likely to increase. No? Bernanke is stuck between a rock and a hard place here. He knows he can do more monetarily. The problem is politically, there are serious forces that would like nothing better than to see the Fed gone.

  3. Neither David B. nor Joao Marcus have yet figured out that Lenin's great dictum explains Fed policy in 2 words: Who? Whom ?

    There are no conundrums. Get a clue gents.

  4. Nanute:

    I agree that the biggest problem is a political one for the Fed. But much of it is a self-inflicted one.

    Interesting point on the interest rate paradox. Have to think more about that one.

  5. ECB:

    Glad you are still reading even though I am driving you crazy with my AD views. Hang in there... there is still a quasi-Austrian in me somewhere.

  6. Assuming Bernanke is trying to do something about unemployment rather than “slouch on the job”, we should always bear in mind the fatuous nature of the “portfolio channel”. It boosts demand only via households with significant “portfolios”. That makes as much sense as boosting demand only via households whose members are more than 6ft tall.

    As to adjusting interest rates, this is equally distortionary. Why boost demand only via entities which are significantly reliant on borrowed money rather than equity finance?

  7. Ralph:

    I sense you are suggesting the Fed do a helicopter drop where the Fed funds a payroll tax cut until nominal GDP returns to trend?

  8. David, Yes that’s right. I think having the central bank create new money and spend it into the economy (or cut taxes) is better than monetary policy alone in a recession. This is advocated by Modern Monetary Theory (or most of its adherents) and in this work.

    This policy would certainly be a good idea in the US right now given that it is presumably those underwater households that have cut spending rather than the rich. But of course the policy requires cooperation between central bank and government – not exactly on the cards in the US right now!