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Bernanke Sets Course for QEII

In a speech this morning, Federal Reserve Chairman Ben Bernanke outlined steps that the central bank could take to increase economic growth.

He said that “overall economic growth has been proceeding at a pace that is less vigorous than we would like,” and that as a result, unemployment may not exceed the increase in the size of the labor force, leading to only small decreases at best in the overall unemployment rate. He seemed to suggest that monetary policymakers have “little or no control over the longer-run sustainable unemployment rate,” which is determined more by demographics and structural factors, but nonetheless he made a case for increasing growth and preventing inflation from getting too low, which he found more within the Fed’s control.

With inflation at a low ebb and not likely to be a concern for the future, Bernanke concluded that, “Given the Committee’s objectives, there would appear–all else being equal–to be a case for further action.” But he made clear that, with interest rates at the zero lower bound, that action may not be traditional in nature, and that it would carry risks and limitations:

For example, a means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve’s holdings of longer-term securities. Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery. A similar program conducted by the Bank of England also appears to have had benefits.

However, possible costs must be weighed against the potential benefits of nonconventional policies. One disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public. These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities.

Another concern associated with additional securities purchases is that substantial further expansion of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations, to a level above the Committee’s inflation objective. To address such concerns and to ensure that it can withdraw monetary accommodation smoothly at the appropriate time, the Federal Reserve has developed an array of new tools. With these tools in hand, I am confident that the FOMC will be able to tighten monetary conditions when warranted, even if the balance sheet remains considerably larger than normal at that time.

Bernanke added nothing about increasing the price level, only including the possibility of signaling that interest rates would remain low for a longer period than expected in the current language. This would help lower long-term interest rates.

Calculated Risk called the speech “less of a framework than I expected,” but the financial press seemed satisfied that Bernanke pointed a path to new asset purchases.

Lurking in the background is the possibility that the Fed could use the quantitative easing to buy up lots of troubled mortgage-backed securities from angry investors who feel defrauded, as a way to defuse the mortgage fraud crisis. That may be a greater near-term priority than any economic stimulus benefit.

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David Dayen

David Dayen