Reflections on Mr. Bernanke’s Speech at Jackson Hole and Future Monetary Policy

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Unlike at his Jackson Hole speech in 2010 when QE2 was presented, Fed Chairman Bernanke did not pull a rabbit out of the policy hat last week.  The focus was not on the immediate outlook for the economy or monetary policy, but more on the structural headwinds facing the US economy and other long-term issues such as fiscal policy.  Mr. Bernanke made two surprises on short-term policy: the lack of discussion about further asset purchases or other easing options and that further policy options will be considered at upcoming FOMC meetings.     

 

He differentiated between the cyclical and structural/secular role of monetary policy, noting that the Fed is less effective when it comes to the latter role.  He reminded his listeners that the Fed alone cannot carry such a heavy policy burden and that fiscal policy was needed to promote growth and stability.  Fiscal policymakers face a fine balancing act “the need to place fiscal policy on a sustainable path” and to avoid “severe economic and financial damage” while noting the fragility of the current environment.  He noted reforms are needed in other areas of economic management, emphasizing the need for a better process for making fiscal decisions.  

 

Mr. Bernanke noted economic policies that support robust economic growth in the long run are outside the province of the central bank.  He implied in the President’s upcoming speech on needed fiscal stimulus and job creation – a constructive and collaborative approach by the Administration and Congress was required.  Another round of damaging policy dithering and political bickering would have strong adverse consequences on the economy.

 

The Fed continues to have a more optimistic view on US economic prospects than most private sector analysts.  The major difference is the Fed assumes that a number of temporary factors that depressed economic activity in the first half will not be present in the second half.  If this view is correct, it would imply that chances for QE3 are minimal.  However, if the Fed view converges to that of private sector, the chances for QE3 increase.  The most likely form would be through increased asset purchases of longer-dated maturities.

 

Other extreme measures would not be considered, unless the economy and financial markets substantially deteriorate below current prospects.  The Fed would have three possible policy options: the extension of the QE program into other markets such as corporate bonds, a sharp increase in the program that extends the Fed’s balance sheet and an explicit or implicit change in the Fed’s policy targets.  However, US economic prospects have not deteriorated enough to consider these options.

Preliminary Thoughts on Bernanke’s Speech at Jackson Hole and Fed Policy Options

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The most important event this week is tomorrow's speech by Fed Chairman Ben Bernanke at the annual Kansas City Fed Conference.  The speech is expected to focus on three elements: the downgrading of US economic prospects, a defense of past policy actions and an outline of Fed policy options.

 

Last year, Mr. Bernanke outlined details for QE II and Fed policy options: the purchase of long-term securities, communication and lowering the interest rate paid on excess reserves.  The Friday speech will most likely focus on:  the possibility of additional purchases of long-term securities and changing the composition of the balance sheet. 

 

The Fed will note the downgrading of US economic prospects, as mentioned in the recent FOMC minutes.  This view will be consistent with the lowering of US growth prospects done by a number of Wall Street (WS) analysts.  The most recent FOMC communiqué noted “a slower pace of recovery in coming quarters” and “downside risks to the economic outlook have increased”.  However, the Fed economic outlook has one key difference from WS analysts as evidenced in recent speeches by Fed officials “weakness in economic activity in the first half was due to temporary factors …” and “restraining forces have abated and thus, we should see stronger growth in the second half”.  This suggests the Fed takes the view that the slowdown was partially caused by temporary factors.  The Fed scenario is for weak growth followed by a modest recovery going into 2012.  This is slightly more optimistic than private sector forecasts.

 

The next point, to be addressed by Mr. Bernanke, is the defense of previous Fed easing efforts.  The combination of weakness in growth and downward revision to economic forecasts raise questions about effectiveness of recent policy efforts.  Previously, he argued that QE helped reduce deflation risk and raised inflation expectations.  Mr. Bernanke will most likely address these issues as follows: the first is that central banks (Fed) cannot be the sole source of stimulus in a global fiscal tightening environment; secondly, one way QE II was successful by avoiding another recession (to date) and deflation; and lastly there is evidence from economic studies that QE does have a positive impact on growth.  The jury is still out on QE II, but it has helped the economy – the question is how much?

 

As indicated earlier, the three options open to the Fed include: communication, asset purchases and balance sheet management and changing the interest rate paid on excess reserves.  The Fed has already implemented a variation of its communication policy by stating that rates will remain low for an extended period.  The Fed will not consider changing the interest rates on excess reserves due to technical aspects of implementation, potential damage to banks from already low rates and questionable impact on bank lending.

 

This leaves the last option of large-scale asset purchases and changing the composition of the balance sheet.  There are studies that suggest that selling short-dated treasuries and buying long-dated can have a significant impact on reducing real rates.  The reason why this option may be favored is that it will not change the size of the Fed balance sheet which would keep politicians happy.  The view among WS analysts is that Mr. Bernanke will present these options, but not pre-commit to any policy action except through the FOMC.  The recent rise in core inflation will keep policymakers cautious.  The use of any unconventional policy options such as a higher inflation target, price level targeting, a long-term interest rate target or option twist (used in the early 1960s) may be considered at a later date.