Politics & Policy

Has Bernanke Gotten the Story Right?

Market monetarists say yes.

The most important point in Ben Bernanke’s Wednesday press conference was the announcement that the Fed will adjust the amount of monthly bond purchases according to economic conditions. In other words, an improving economy with stronger payrolls and lower unemployment could lead to a decline in Fed bond buying, from $85 billion a month to something gradually lower, so long as the economy keeps looking better.

It won’t happen all at once. The Fed is not convinced that the current economic upturn is truly sustainable. But Bernanke is implying that the Fed may become less easy in the second half of this year, perhaps ending QE in 2014.

The zero-interest-rate target will unfortunately remain in place much longer — until unemployment goes to 6.5 percent or less. Given rising tax and regulatory threats from Washington, and the job-stopping Obamacare regulations and mandates, unemployment may be sticky on the downside.

But the big news is that the Fed may stop growing its balance sheet sooner than most market people expect. As someone who is totally uncomfortable with the Fed’s $4 trillion balance sheet and reserve-creation process, I welcome the news. The central bank is listening to its critics, both inside and out.

#ad#And it’s worth noting that a mild economic upturn is in the cards, perhaps driving real GDP toward 3 percent. Lower jobless claims, stronger housing numbers, and a rebound in the index of leading indicators confirm the better economic trend. Highly respected economists Conrad DeQuadros and John Ryding point to a broad range of indicators that “show an upswing in economic activity.”

But an important alternative view is saying “not so fast.” The old Milton Friedman monetarists have been reborn as the “market monetarists.” And these folks say the Fed should move very cautiously toward a less-accommodative policy.

In particular, they point to sub-par growth in nominal GDP — or total spending in the economy (real output plus inflation). Nominal GDP is trending at only 4 percent or slightly less. So the market monetarists say the Fed should keep adding reserves until nominal GDP moves up to 5 percent, perhaps including 3 percent real output and 2 percent inflation.

The market monetarists think the Fed has not been so easy.

In this vein, economist Michael Darda argues that Fed reserve creation and its unemployment target (the 6.5 percent Bernanke-Evans rule) has only partially offset a negative velocity shock of historic proportions. This, says Darda, is why the economy has been so weak.

Economist Scott Grannis adds that the Fed is not really “printing money.” Yes, the central bank has purchased the incredible sum of nearly $2.5 trillion in Treasury and mortgage bonds. But most of that has not been put to work by banks or consumers. Grannis argues that consumers have increased their cash balances and that banks are holding onto extra reserves in order to avoid risk following the financial meltdown. As a result, the M2 money supply has been growing at a fairly steady rate of 6 to 7 percent. Not an excessive pace.

Meanwhile, M2 has grown much faster than nominal GDP. Consequently, the velocity (or turnover rate) of money has been falling for years.

All this is to say that the demand for cash and cash equivalence by consumers and banks is so strong in a risk-averse environment that all the Fed has really done is meet those cash demands. It’s not working the printing presses overtime.

In fact, the inflation rate during this whole period has been trending around 2 percent or less, far below the expectations of Fed critics (including myself). Over the past year, M2 growth has been about 7.5 percent and M2 velocity has fallen by about 3.5 percent. So the rise in nominal GDP is a historically low 3.5 percent.

Interestingly, while the inflation rate has remained subdued, so have market-price indicators, such as gold, the dollar, and commodity indexes. The suggestion here is that Bernanke, rather than mounting a high-inflation policy, has been avoiding deflation.

At the end of the day, the Federal Reserve is not the engine of growth. Low tax rates, light regulation, and limited government spending create the incentives for more rapid economic expansion and prosperity-inducing opportunities.

But if I have this story right, the market monetarists want the central bank to enforce a nominal GDP growth rule, which will avoid both deflation and inflation, and thus give fiscal incentives breathing room for a more rapid job-creating expansion.

I don’t agree with Bernanke’s unemployment target or his criticism of lower government spending. But I confess that he may have the monetary-stability story more right than I originally thought.

If gold remains soft, and King Dollar steady, perhaps the former Princeton professor deserves a little more credit. He may have gotten that story right.

Larry Kudlow is the author of JFK and the Reagan Revolution: A Secret History of American Prosperity, written with Brian Domitrovic.

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