Can a Divided Fed Stand? Or Will It Fall?

Gavyn Davies Financial Times July 13, 2011

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Ben Bernanke. Image by EPA.

The financial markets seem determined to interpret todayâ??s statement by the Fed chairman in a dovish light, but a careful reading of his words does not support that point of view. True, Mr Bernanke outlined the possible ways in which monetary policy might be eased further if recent economic weakness should prove more persistent than expected. But he gave equal weight to the possibility that â??the economy could evolve in a way that would warrant less-accommodative policyâ?.

There was no hint in the text about which of these outcomes he considered the more likely. We already knew from yesterdayâ??s FOMC minutes for the June meeting that the committee is split about the likely evolution of policy, and we were waiting to see today whether the chairman would throw his weight behind either the doves or the hawks. He failed to do either.

Mr Bernankeâ??s description of the economic background was almost exactly the same as he offered after the June meeting. Economic activity was described as weaker than expected, and not all of that weakness was attributed to temporary factors. In his central view, growth would rebound in the second half of the year, but there was considerable emphasis on the continuing weakness of the labour market. Meanwhile, on inflation, some of the recent rise was also attributed to temporary factors, but the entire emphasis was on the headline rate, which he said had been running at over 4 per cent so far this year. There was no mention whatsoever of the much lower core inflation rate, a previous favourite of the chairmanâ??s.

In other words, his overall message was that the economy might be undesirably weak, but that inflation was too high for the Fed to be able to respond to that weakness. That is the main point which we should all take from todayâ??s evidence: no imminent change in policy is likely.

In the section on possible policy easing in the future, Mr Bernanke made it plain that this would only apply if economic weakness proved more persistent than expected, and if deflationary risks reemerged. Note that economic weakness alone would not be sufficient. That is the key difference, in his mind, between now and last year. This year, there is no deflationary threat, and therefore no reason to contemplate further unconventional easing. The Fed Chairman has now said this so many times that the markets might one day start to pay attention.

Nor did he necessarily promise a full dose of QE3, even if the economy should weaken further, and deflation risks should reemerge. His check list of possible easing measures included all of those he has mentioned before. But many of them would have very little effect. For example, with the markets already expecting the federal funds rate to stay at zero for most of next year, would it really make much difference if the Fed formally committed itself to hold rates at zero for a longer period? Would a cut in the rate paid by the Fed on reserve deposits held by the banks, from the current 25 basis points, really induce them to lend more? And would it matter much if the Fed increased the average maturity of its security holdings? On all counts, it seems very doubtful.

Why is the Fed chairman apparently so reluctant to take further measures to stimulate demand, when he views the outlook for unemployment with considerable pessimism? In the short term, the rise in inflation explains this, and it is hard to blame him for that. But, in the longer term, he may be having some doubts about the extent to which structural unemployment has risen. Certainly, the FOMC is now deeply split on this issue, and that constrains the chairmanâ??s freedom for manoeuvre.

Until now, Mr Bernankeâ??s intellectual framework has been very consistent. High unemployment has, in his view, been due mainly to a shortage of aggregate demand. Furthermore, he has always believed that monetary policy is powerful enough to address this problem, even with interest rates at the zero bound. However, doubts appear to be creeping in.

Today, while he described the unemployment level as â??a crisisâ?, he said that long term unemployment â??leads to an erosion of skillsâ?¦and impairs lifetime employment prospects and reduces the productive potential of our economyâ?. This implies that he is beginning to suspect that part of the rise in unemployment might be structural, and therefore outside the realm of monetary policy. An alternative point of view, which is that this makes it imperative to prevent long term unemployment from building up in the first place, does not appear to be on his agenda. (It is not clear, incidentally, why he believes this about structural unemployment, since the bulk of research done recently by labour market economists at the Fed points clearly in the opposite direction.)

He also said that his expectations of the employment effect of QE2 had been â??relatively modestâ? at around 30,000 extra jobs per month. This suggests that, anyway, the scale of further QE which would be needed to make much of a dent in the unemployment problem is outside the bounds of what he deems feasible for the Fed in present circumstances. So he has lost some of his earlier confidence not only in the intellectual case for further action, but also in its feasibility and likely effectiveness.

The Fed is divided, and the chairman is not currently in the frame of mind to impose his earlier thinking on the FOMC. Maybe he is just biding his time. But the situation would have to worsen considerably before he takes more stimulative action.

Related reading:

Coverage of Ben Bernankeâ??s testimony before Congress â?? FT Money Supply

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Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.

He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.

Can a Divided Fed Stand? Or Will It Fall?

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