Fed Chairman Ben Bernanke made an important speech this morning in which he discussed monetary policy in a low interest rate, low inflation environment. Below I present key passages from the speech along with my interpretation/translation.
“Although the attainment of price stability after a period of higher inflation was a landmark achievement, monetary policymaking in an era of low inflation has not proved to be entirely straightforward. In the 1980s and 1990s, few ever questioned the desired direction for inflation; lower was always better.”
Now, with a very real threat of deflation, that is no longer the case. At any given level, deflation is a much more serious economic problem than inflation. The economy can do very nicely with 3% inflation, but with 3% deflation, it would come to a near stop. High inflation is a bad thing, but negative inflation (aka deflation) is even worse.
“A second complication for policymaking created by low inflation arises from the fact that low inflation generally implies low nominal interest rates, which increase the potential relevance for policymaking of the zero lower bound on interest rates. Because the short-term policy interest rate cannot be reduced below zero, the Federal Reserve and central banks in other countries have employed nonstandard policies and approaches that do not rely on reductions in the short-term interest rate.”
We are still learning about the efficacy and appropriate management of these alternative tools.
In a “normal” recession, the best policy tool available is generally monetary policy. The economy slows and the Fed cuts the Fed funds rate. However, the Fed cut interest rates almost to zero almost two years ago. The rate that they would like to cut it to, based on the normal monetary policy rules of thumb (most notably the “Taylor Rule” would imply that the rate should be about -4.0%, but the rate cannot fall below zero).
The conventional ammunition was spent a long time ago, and the Fed has had to turn to unconventional methods. Because the unconventional methods have not really been used much before, trying to gauge things like how much is enough, how much is too much and what is the optimal timing and pace of moves is very difficult.
“An economic recovery began in the United States in July 2009, following a series of forceful actions by central banks and other policymakers around the world that helped stabilize the financial system and restore more-normal functioning to key financial markets. The initial upturn in activity, which was reasonably strong, reflected a number of factors, including efforts by firms to better align their inventories with their sales, expansionary monetary and fiscal policies, improved financial conditions, and a pickup in export growth.
“However, factors such as fiscal policy and the inventory cycle can provide only a temporary impetus to recovery. Sustained expansion must ultimately be driven by growth in private final demand, including consumer spending, business and residential investment, and net exports. That handoff is currently under way. However, with growth in private final demand having so far proved relatively modest, overall economic growth has been proceeding at a pace that is less vigorous than we would like.”
We got a nice pop from the inventory cycle, and the fiscal stimulus from the ARRA did help for awhile, but now inventories are back to normal, and the effects of the ARRA are starting to wear off. The de-stimulus at the state and local levels continues as strained budgets are forcing them to cut spending and raise taxes.
The lack of residential investment has been the key reason why this has been such an anemic recovery, and that is not likely to change anytime soon, given the massive overhang of existing homes for sale and the whole foreclosure mess. Exports are growing, but unfortunately imports are growing faster, and it is net exports, not exports alone, that is important to economic growth. It is not clear if the hand-off will be fumbled or not.
“In particular, consumer spending has been inhibited by the painfully slow recovery in the labor market, which has restrained growth in wage income and has raised uncertainty about job security and employment prospects. Since June, private-sector employers have added, on net, an average of only about 85,000 workers per month — not enough to bring the unemployment rate down significantly.
“Consumer spending in the quarters ahead will depend importantly on the pace of job creation but also on households’ ability to repair their financial positions. Some progress is being made on this front. Saving rates are up noticeably from pre-crisis levels, and household assets have risen, on net, over recent quarters, while debt and debt service payments have declined markedly relative to income.”
People who are out of work, or are afraid that they might be soon, don’t spend as freely as people with secure jobs. The loss of wealth from the bursting of the housing bubble has been huge, and people are struggling to offset that by saving more out of current income, thus depressing overall demand, and resulting in high unemployment.
But it is very hard to save when you are out of work. Still, those who still have jobs have increased their savings enough that we have seen a fairly dramatic increase in the savings rate, although it still remains far below what was considered normal back in the 1960’s and 1970’s. While a high savings rate is good over the long term, and increasing savings rate is a powerful brake on economic growth. Unfortunately, there is no way to go from a low savings rate to a high savings rate without the savings rate increasing.
“In the business sector, indicators such as new orders and business sentiment suggest that growth in spending on equipment and software has slowed relative to its rapid pace earlier this year. Investment in nonresidential structures continues to contract, reflecting stringent financing conditions and high vacancy rates for commercial real estate.”
With lots of unused capacity businesses see little reason to invest in creating more capacity. Most of the investment in equipment and software was probably aimed at equipment that cuts costs (mostly by allowing a single employee to do the work several would have had to have done without the new equipment) rather than increases output. On the construction side, why build when there are so many existing vacant buildings that could be used?
