The Corner

Why Bernanke’s QE Justifications Don’t Wash

When Ben Bernanke became chairman of the Federal Reserve, he was known to have a long history of championing transparency. He believed, correctly, that a more transparent Fed would lead to more effective monetary policy, less disruptive changes in that policy, and greater confidence in the Fed’s independence from political interference. In light of the recent bipartisan opposition to his new quantitative easing (QE) program, he needs to try harder.

Bernanke faces a difficult dilemma. He can offer flimsy explanations for his new QE policy, explanations that simply will not stand up to scrutiny, or he can explain his thinking fully and risk jumping right into the middle of the biggest political fight of the day, taxes.

The policy at issue is an important variation on traditional monetary policy. Traditionally, the Fed tries to steer the economy, with a sharp eye on inflation, by steering short-term interest rates up or down. The new QE program involves the Fed buying longer-term securities to steer long-term interest rates downward while injecting more liquidity into the capital markets. This policy is disconcerting, because when central banks purchase government debt (i.e., monetize the debt), it is often a big step toward hyperinflation. The difference under this QE is that the Fed will supposedly sell the debt back to the markets sometime in 2011 or 2012. But that’s a future that must be taken on faith today.

In a recent article, Bernanke argued that inflation was very low, perhaps too low, and that “very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.” He also argued that “there is considerable spare capacity” in the economy, which normally puts downward pressure on prices. Both statements are clearly true.

In an earlier speech, Bernanke said that growth in 2011 was unlikely to be “much above its longer-term trend,” which means that the “unemployment rate will decline only slowly.” True again.

The conflict in these two statements may not be immediately obvious, but consider: If the economy is growing near its trend rate in 2011, as Bernanke suggests, then there is little to no risk of deflation. Strong growth is a powerful antidote to deflation worries. Either the deflation risk is vastly overstated and QE is therefore unjustifiable, or Bernanke believes growth in 2011 will continue to be anemic at best.  

The economy has averaged less than 1 percent annualized growth in recent quarters, once transitory inventory and federal spending surges are weeded out. What Bernanke is silently worried about is the possibility that Congress will allow all the 2001 and 2003 tax relief to expire at the end of the year, or that Congress will allow those provisions most important to the economy to expire — e.g., the lower tax rates on small businesses and the lower rates on capital gains and dividends. Slamming a sputtering economy with a major tax hike threatens to induce another recession, and with inflation already near zero, the possibility of deflation becomes very real. But Bernanke can’t or won’t say so.

Bernanke’s QE justifications don’t wash. If the economy is expected to muddle through, let alone accelerate, then there is no reason to embark on a highly risky, highly controversial new round of quantitative easing.

Why won’t Bernanke be transparent in this? Because he also worries about the Fed’s independence. Imagine President Obama’s reaction if the chairman of the Federal Reserve were to point out the obvious truth that the economy dare not sustain a massive tax hike at this time. Or if he were to say that the prospect of such a tax hike is what forced the Fed’s hand on QE, despite the risks. Whatever Bernanke’s intentions, this would be interpreted as a blatantly partisan act by the non-partisan Fed.

Bernanke can either base his QE policy on flimsy arguments and face growing opposition, or he can exercise the transparency he once championed by explaining that his policy is a reaction to the likelihood of an ill-advised tax hike, jumping into a highly partisan snake pit. It is a difficult choice. Bernanke has thus far made the wrong choice, but there is still time for him to correct his mistake.

J. D. Foster is the Norman B. Ture senior fellow in the economics of fiscal policy at the Heritage Foundation.

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