Ben Bernanke: The Fed Does Less Monetary Stimulus Than It Thinks Is Warranted Because It Is Afraid of the Side Effects of Unconventional Tools

On January 14, 2013, Ben Bernanke came to a Q&A session at the University of Michigan, sponsored by the Ford School of Public Policy. Here is the video and the full transcript can be found here. I thought Ben said some particularly important things about the use of unconventional tools of monetary policy and about financial stability. Let me excerpt four question and answer exchanges. I consider the last of the four the most important.

The Effectiveness of Quantitative Easing

Susan Collins (Dean of the Ford School): …the Fed, of course, has been keeping interest rates at close to zero since roughly 2008. And it’s dug pretty deep into its arsenal and very unconventional policies more recently in terms of, in particular, the very massive asset purchases recently launched its third round which are intended to bring long-term interest rates. Can you tell us how well you think that is working?

Ben Bernanke: So, to go back just one step, as you said, we’ve brought the short-term interest rate down almost to zero. And for many, many years, monetary policy just involved moving the short-term, basically, overnight interest rate up and down and hoping that the rest of the interest rates would move in sympathy. Then we hit a situation in 2008 where we had brought the short-term rate down about as far as it could go, almost entirely to zero. And so, the question is, what more could the Fed do? And there were many people–a decade ago, there were a lot of articles about how the Fed would be out of ammunition if they got the short-term rate down to zero. But a lot of work by academics and others, researchers at the central banks suggested there was more that could be done once you got the short-term rate down to zero. And in particular, what you could do is try to address the longer term interest rate, bring longer term rates down. And there are two basic ways to do that. One way is through talk, communication, sometimes called open mouth operations. [Laughter] The idea being that if you tell the public that you’re going to keep rates low in the long-term, that that will have the effect of pushing down longer term interest rates. But the quest–the one you’re asking about is what we call at the Fed large scale asset purchases or otherwise known as QE. The idea there is that by buying large quantities of longer term treasury securities or mortgage-backed security so that we can drive down interest rates on those key securities. And that, in turn, affects spending investment in the economy. The latest episode, you know, so far, we think we are getting some effect. It’s kind of early. But overall, it’s clear that through the three iterations that you refer to that we have succeeded in bringing longer-term rates down pretty significantly, and a clear evidence of that would be mortgage rates, as you know, a 30-year mortgage rate is something like 3.4 percent now, incredibly low. And that, in turn, makes housing very affordable. And that, in turn, is helping the housing sector recover, creating construction jobs, raising house prices, increasing activity in that sector, real estate activity, and so on. So, I think broadly speaking, that we have found this to be an effective tool. But we’re going to continue to assess how effective, because it’s possible that as you move through time and the situation changes that the impact of these tools could vary. But I think what we have decisively shown is that the short-term interest rate getting down to zero, but economists call it the zero lower bound problem, it does not mean the Fed is out of ammunition. There are still things we can do, things we have done. And I would add that other central banks around the world had done similar things and have also had some success in creating more monetary policy support for the economy….

Inflation and Financial Stability Risks of Fed Stimulus

Susan Collins: And I wonder what you might say to those who argue that … the massive asset purchases have created extremely high risks, perhaps, under appreciated risks for future inflation.

Ben Bernanke: …the Federal Reserve has a dual mandate from the Congress to achieve or at least to try to achieve price stability and maximum employment. Price stability means low inflation. We have basically taken that to be two percent inflation. Inflation has been very low. It’s been below two percent and appears to be on track to stay below two percent. So, our price stability record is very good. Unemployment, though, as we’ve already discussed, is still quite high. It’s been coming down but very slowly. And the cost of that is enormous in terms of lost, you know, lost resources, hardship, talents and skills being wasted. So, our effort to try to create more strength in the economy, to try and put more people back to work, I think that’s an extraordinarily important thing for us to be doing. And I think it motivates and justifies what has been, I agree, an aggressive monetary policy. So, that’s what we’re doing and that’s why we’re doing it. Now, are there downsides? Are there potential costs and risks? There are some. You mentioned inflation. We have, obviously, used very expansionary monetary policy. We’ve increased the monetary base which is demand reserves that banks hold with the Fed. There are some people who, I think, that’s going to be inflationary. Personally, I don’t see much evidence in that. Inflation, as I’ve mentioned has been quite flow. Inflation expectations remain quite well-anchored. Private sector forecasters do not see any inflation coming up. And in particular, we have, I believe, we have all the tools we need to undo our monetary policy stimulus and to just–to take that away before inflation becomes our problem. So, I don’t believe that significant inflation is going to be a result of any of this. That being said, price stability is one part of our tool mandate, and we will be paying very close attention to make sure that inflation stays well contained as it is today. A second issue, I think, probably worth mentioning is financial stability. This is a difficult issue. The concern is–has been raised at–by keeping interest rates very low, that we induce–the Federal Reserve induces people to take greater risks in their financial investments, and that, in turn, could lead to instability later on, again, a difficult question. In fact, I could take the rest of the hour talking about this, so I don’t think I’ll do that. But what I will say is that we are, first of all, very engaged in monitoring the economy, the financial system. The Fed has increased enormously the amount of resources we put into monitoring financial conditions and trying to understand what’s happening in different sectors of the financial markets. We’ve also, of course, been part of the very extended effort to strengthen our financial system by increasing capital in banks, by making derivatives and transactions more transparent, by stiffening supervision, and so on. So, we are taking measures to try both to prevent financial instability and to identify potential risks that we would then address through regulatory or supervisory methods. So, we’re very much attuned those–to these issues. But once again, I think this is something that we need to pay careful attention to. And as I–as we discussed in our statement and have for a while, as we evaluate these policies, we’re going to be looking at the benefits which, I believe, involve some help to economic growth to reduction in unemployment. But we’re also going to be looking at cost and risk. We have a cost benefit type of approach here. We want to make sure that the actions we’re taking are fully justified in a cost benefit type of framework. …interest rates will eventually rise. We hope they rise, because that means the economy will be strengthening. So, you know, we’re not going to playing games with that. We are going to follow our mandate, which means do what’s necessary to help the economy be strong. … Indeed, I think the worst thing we could do would be if we raise interest rates prematurely and caused recession, that would greatly increase budget deficits.

Monetary vs. Regulatory Approaches to Financial Stability

Audience Question: Do you believe that the Fed should actively prevent future asset bubbles and if so what tools do you have to do that?

Ben Bernanke: Well, asset bubbles have been–they’re very, very difficult to anticipate, obviously. But we can do some things. First of all, we can try to strengthen our financial system, say, by increase–as I mentioned earlier, by increasing the amount of capital liquidity the banks hold, by improving the supervision of those banks, by making sure that every important financial institution is supervised by somebody. There were some very important ones during the crisis that essentially had no effective supervision. So you make the system stronger that if a bubble or some other financial problem emerges, the system will be better able to be more resilient, will be better able to survive the problem. Now, you can try to identify bubbles and I think there has been a lot of research on that, a lot of thinking about that. We have created a council called the Financial Stability Oversight Council, the FSOC, which is made up of 10 regulators and chaired by the Secretary of the Treasury. One of whose responsibilities is to monitor the financial system as the Fed also does and try to identify problems that emerge. So, you’re not going to identify every possible problem for sure but you can do your best and you can try to make sure that the system is strong. And when you identify problems, you can use–I think the first line of defense needs to be regulatory and supervisory authorities that not only the Fed but other organizations like the OCC and the FDIC and so on have as well. So you can address these problems using regulatory and supervisory authorities. Now having said all that, as I was saying earlier, there’s a lot of disagreement about what role monetary policy plays in creating asset bubbles. It is not a settled issue. There are some people who think that it’s an important source of asset bubbles, others would think, it’s not. Our attitude is, that we need to be open-minded about it and to pay close attention to what’s happening and to the extent that we can identify problems. You know, we need to address that. The Federal Reserve was created in about 100 years ago now, 1930 was the law, not to do monetary policy but rather to address financial panics. And that’s what we did, of course, in 2008 and 2009. And it’s a difficult task but I think going forward, the Fed needs to think about financial stability and monetary economics stability as being, in some sense, the two key pillars of what the Central Bank tries to do. And so we will, obviously, be working very hard in financial stability. We’ll be using our regulatory and supervisory powers. We’ll try to strengthen the financial system. And if necessary, we will adjust monetary policy as well but I don’t think that’s the first line of defense.

Costs and Benefits of Unconventional Tools of Monetary Policy

Question Tweeted In: This question comes from Twitter. Since the Fed declared it was targeting a two percent inflation rate in January of 2012, the FOMC has released its projections five times. And each one of these projections, the inflation rate has come in below this target. Why then has the policy been set to concessively undershoot the target?

Ben Bernanke: Was that 140 characters? [ Laughter ] I suspect many in our audience had related questions. [Laughter] Yeah. That’s a very good–it’s a very good question and let me try to address. As I said earlier when Dean Collins was asking me about the risks of some of our policies, I was pointing out that inflation is very low. Indeed, it’s below the two percent target and unemployment is above where it should be and therefore, there seems to be a pretty strong presumption that we should be aggressive in monetary policy. So, you know, I think that that does make the case for being aggressive which we are trying to do. Now, the additional point that I made, though, was that, you know, the short-term interest rate is close to zero and therefore we are now in the world of non-standard monetary policy [inaudible] asset purchases and communications and so on. And as we were discussing earlier, we have to pay very close attention to the costs and the risks and the efficacy of these non-standard policies as well as the potential economic benefits. And to the extent that there are costs or risks associated with non-standard policies which do not appear or at least not to the same degree for standard policies then you would, you know, economics tells you when something is more costly, you do a little bit less of it. We are being quite accommodative. We are working very hard to try to strengthen the economy. Inflation is very close to the target. It’s not radically far from the target. But in trying to think about what the right policy is, we have to think not only about the macroeconomic outlook which is obviously very critical, but also the costs and risks associated with the individual policies that we might apply.