Return of the Chairman

August 25, 2011

Hope has ebbed progressively all week that Federal Chairman will pre-announce a new monetary stimulus in his Jackson Hole speech Friday, just as he did exactly a year ago.  Not only did central bank spokesmen say nothing during the week to encourage the high hopes of last Monday, but the press and business talk shows have been flooded with analysts dismissing the likelihood of any shock and awe in his speech.  A central theme these past four days has been that another dose of monetary stimulus would be pointless or counterproductive.

Many arguments were marshaled to downplay the usefulness of more Fed support.  The employment/inflation tradeoff is different than it was a year ago.  In a liquidity trap with real interest rates already negative, monetary policy is the wrong tool.  Recent data have in fact been mixed.  More liquidity would not cut unemployment and might lead to more intractable inflation.  An encore of the Chairman’s speech a year ago would invite greater political efforts to strip the Fed of its institutional independence.  Monetary policy mustn’t allow itself to be bullied by the stock market, or a whole new dimension of moral hazard would be introduced into the U.S. economy.

For the record, the Chairman presented something much less concrete a year ago than legend has it.  He noted then that consumption and investment were recovering more slowly than hoped and that CPI inflation was somewhat lower than a working definition of price stability.  He rejected passive tightening, which otherwise would happen if the central bank did not reinvest the principle of maturing securities, and he noted that the end of QE1 had not caused interest rates to rise.  If the Fed did nothing new, policy would be very accommodative, and any deployment of fresh stimulus would entail costs as well as benefits that would have to be considered carefully.  His August 2010 speech laid out some possible stimulative measures that could be taken if needed but underscored that as yet no agreement on specific criteria that could trigger such action had been reached.  He ducked being drawn into fiscal recommendations, but warned that monetary policy cannot solve all problems alone.  In response to those comments, which proved a precursor to QE2 announced by the FOMC on November 3, ten-year Treasury yields jumped 12 basis points, gold soared, and oil prices slipped.  The dollar had a comparatively modest immediate response.

In the year since that speech, U.S. consumer price inflation has tripled from 1.2% to 3.6%, and the core rate has doubled to 1.8%.  The ten-year yield of 2.42% now compares to 2.52% at the start of last year’s speech and 2.64% at the end of that day.  Jobs have grown 1.258 million, or 105K per month, and the current 9.1% unemployment rate is just four-tenths of a percentage point lower than a year ago.  At that rate of decline, it will take eight years to fall to 6.0%, but in fact that interval will be longer because it’s unreasonable to expect economic recovery to span eight years without breaking for another recession.  One comparison in which the U.S. was stronger then than now involves real GDP growth.  Newly revised data show that real GDP had expanded in 2010 at rates of 3.9% annualized in the first quarter, 3.8% in the second quarter, 2.5% in 3Q (when Bernanke spoke at Jackson Hole) and 2.3% in 4Q.  This year, GDP edged up just 0.4% in the first quarter and seems likely to be revised downward to no higher than 1.0% for the second quarter.  Opponents of monetary stimulus will no doubt maintain that such proves that monetary stimulus in present circumstances in fact weakens the economy both in the short term and the long term.

Those who warn against bowing to stock market weakness often bring up the experience of 1987, when a single-day crash of 22.6% in the DOW on October 19 failed to produce a recession.  GDP in fact expanded at a sizzling 7.0% in 4Q87, followed by 2.1% in 1Q88, 5.2% in 2Q, 2.1% in 3Q and 5.4% in 4Q88.  It should be also pointed out that GDP had risen 4.3% in the second quarter of 1987 and 3.5% in the third quarter.  In other words, the crash landed on a strong economy, which could absorb momentary blows to consumer and business confidence.  The present economy has slowed to stall speed.  The United States is maybe one shock away from tumbling back into a downturn, and perhaps the European debt crisis has already lit the fuse.  Business and consumer confidence already are reeling.

Listening to the talk shows, I heard more than one pundit downplay the likely negative reaction if Bernanke fails to hint of coming stimulus.  I suspect that today’s rocky equity price action is a foretaste of what should be expected.  Now Bernanke doesn’t have to throw red meat to the wolves.  Monetary policy is the wrong tool.  Unfortunately, it’s the only tool, since Congress has other agendas and the president is out of favor.  Still, words matter, and Bernanke could create some hope if he chooses his words wisely.  People need to know that policy options are still available, and the chairman should not hesitate this time to enter the fiscal policy debate.  Remarks by his predecessor were the catalyst for the infamous Bush tax cuts of 2011. 

I think U.S. demand management is going to make another turn toward greater support.  It could happen by design, but time is getting short.  If not by design, there’s always the force of market circumstances.  U.S. stock prices after today’s setback are slightly closer to levels a year ago than to those on July 21 when the recent slide kicked into higher gear.  By the tenth anniversary of the 9-11 attacks, stock indices might have given back all of their post-Jackson Hole 2010 gains, and commentators will be uttering that R-word with even greater frequency.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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