Politics & Policy

The Bernanke Era’s Second Error

Global financial markets have not been pleased at the monetary tightening.

The Federal Reserve Act states that the U.S. central bank’s chairman can “be removed [only] for cause by the President.” Kind of vague. Does monetary-policy malfeasance qualify? Of course, since Ben Bernanke is almost certainly a short-timer, such radical action is hardly worth the bother. And in truth, the suggestion isn’t a serious one. If Washington or any other rich economy dumped central bankers for every mess-up, their longevity would be roughly that of a Spinal Tap drummer.

Still, it appears the Fed has now made its second significant error of the Bernanke era, a blunder that merits a thorough thrashing.

The first major mistake was Team Bernanke’s passive tightening in 2008 as the economy suffered through an imploding housing bubble and spiking oil prices. As economist Robert Hetzel, of the Federal Reserve Bank of Richmond, has pointed out, the bank not only left short rates alone between April and October as the economy deteriorated, but it also effectively tightened monetary policy as hawkish statements from its members raised the expected path of the federal-funds rate. That in turn helped further collapse demand, turned a modest recession into the Great Recession, and sparked the Financial Crisis. (Warning: This is, frustratingly, a narrative rarely presented by either the MSM or the conservative blogosphere.) Since then, the Bernanke Fed has engaged in just enough monetary easing — through its on-and-off bond-buying programs — to avoid depression and, more recently, offset U.S. fiscal austerity. Granted, no small achievement.

Last week, however, the Bernanke Fed more or less washed its hands of America’s slow-growth, high-unemployment economy with a de facto monetary tightening. Based on the chairman’s press conference after last week’s policymaking meeting, the Fed apparently sees the economy as having enough vigor to merit scaling back asset purchases at either its September or December meetings, ending them in 2014, possibly followed by interest-rate hikes later that year or in early 2015.

Global financial markets have not been pleased.

And with good reason. Inflation is below 2 percent, and unemployment over 7 percent (over 9 percent if you factor in the massive decline in labor-force participation). With the EU stuck in recession, and China slowing, the U.S. should again assume the role of global growth engine. There’s a powerful and compelling argument that the Fed should be maintaining or even expanding its asset buys, or at least offering much stronger and clearer guidance about intentions to return the economy back to pre-recession levels of nominal GDP and employment. Expectations are a powerful tool, one that is now being mishandled. As Goldman Sachs economist Jan Hatzius sees things, a tightening in financial conditions already suggests we ‘ll see about a 0.3 percentage-point hit to real GDP growth over the next year.

Isn’t it time to “end the addiction” and “wean the patient” off Fed stimulus, to use the preferred medical metaphors of the anti-quantitative-easing crowd? Such monetary moralizing misses a big point: Since 2008, the U.S. economy has been suffering through a series of negative shocks to money demand, which the Federal Reserve has failed to fully satisfy. The Fed has not been doing its job. For instance: The cash- and bond-heavy composition of household assets still suggests Americans want to be pretty liquid, reflecting their lack of certainty about future nominal income. Oh, and despite a backup, interest rates both here and abroad remain exceptionally low.

None of this means the fiscal side has no role to play. Tax and regulatory reform are critical to raising the economy’s growth potential. (And thank heavens for the energy boom.) It was a combination of bad monetary and fiscal policy that kept the economy depressed during the 1930s. Between a tighter Fed and the tax hikes of the fiscal cliff and Obamacare, history won’t repeat itself over the next few years, but it just might rhyme.

— James Pethokoukis, a columnist, blogs for the American Enterprise Institute.


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