Bernanke Op-Ed

What the Fed did and why: supporting the recovery and sustaining price stability

By Ben S. Bernanke

November 4 (Washington Post) — Two years have passed since the worst financial crisis since the 1930s dealt a body blow to the world economy.

Only because policy makers failed to respond with an appropriate fiscal adjustment.

And, worse, they continue to fail to recognize this policy blunder.

Working with policymakers at home and abroad, the Federal Reserve responded with strong and creative measures to help stabilize the financial system and the economy. Among the Fed’s responses was a dramatic easing of monetary policy – reducing short-term interest rates nearly to zero. The Fed also purchased more than a trillion dollars’ worth of Treasury securities and U.S.-backed mortgage-related securities, which helped reduce longer-term interest rates, such as those for mortgages and corporate bonds. These steps helped end the economic free fall and set the stage for a resumption of economic growth in mid-2009.

In Q3 08 the Fed failed to provide sufficient routine bank liquidity for several critical months while it experimented with a variety of poorly thought out open market operations that progressively accepted more and more bank collateral until they eventually did what they should have all along- lend to member banks at their target rate on a continuous, as needed basis. Yet even now they fail to do this to the smaller community banks, whose cost of funds remains at least 1% over the fed funds rate.

They also continue to fail to recognize that their role is setting the term structure of risk free rates, which can be done directly.
By simply offering to buy tsy securities at their target rates in unlimited quantities.
However, they have yet to fully appreciate that it’s the resulting interest rates and not the quantities they purchase that are of further economic consequence. And if they wish to specifically target mortgage rates, this is readily done by lending to their member banks specifically for this purpose at the Fed’s desired target for mortgage rates, with the Fed assuming the ‘convexity’ risk.

Additionally, while the Fed did address the ‘market functioning’ issues that were caused by the Fed’s own initial lack of liquidity provision, they failed to recognize that monetary policy was not going to restore aggregate demand. In fact, they were all but certain it would, as evidenced by their concern their policies carried the risk of generating ‘inflation, etc.’ this led other policy makers to take a ‘wait and see’ attitude which has been monumentally costly with regards to lost real output and all the real costs of unemployment.

Notwithstanding the progress that has been made,

After more than two years the output gap in general remains at near record levels.

when the Fed’s monetary policymaking committee – the Federal Open Market Committee (FOMC) – met this week to review the economic situation, we could hardly be satisfied. The Federal Reserve’s objectives – its dual mandate, set by Congress – are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.

The fed’s responsibility for this is largely that of its failure to do its job of providing continuous and unlimited liquidity to its member banks and to not recognize that monetary policy was not capable of restoring the aggregate demand necessary to support full employment.

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy – especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.

Morph? Inflation deteriorates to unwelcome deflation with a lack of aggregate demand. There is no mystery here.

Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating.

Note the continued failure to recognize monetary policy has no tools to support demand at desired levels.

The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

These are all very weak channels at best.

What is hoped for is that lower interest rates encourage private credit expansion, where consumers return to borrowing to spend. And while this can happen, and may already be happening to a small degree, there is no reason to believe that QE will promote this outcome.

What the chairman knows and fails to discuss are the interest income channels, which he wrote about in a published paper in 2004. Lower rates cause the treasury to pay less interest on its treasury securities, and the interest the Fed earns on its newly purchased securities is interest no longer earned by the economy which previously held those securities. This reduced interest income paid by govt to the non govt sectors is much like a tax increase that to some degree neutralizes the modest positive effects the Fed is hoping for.

Also ignored is the fact that Japan has had near 0 rates and much lower long rates than the US, also helped by massive QE, and has also had very large net exports helping to support GDP, something the Fed and the US administration aspires to as well, yet has failed to restore desired aggregate demand, growth, and employment.

While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting.


As monopoly provider of net clearing balances (reserves) for the payments system, the Fed is necessarily ‘price setter’ of the term structure of risk free rates. Their notion of ‘cost’ is inapplicable. And all QE does is alter the duration of total govt liabilities. It doesn’t change the quantity of non govt net financial assets.

We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Agreed! Yet their expressed motivation all along is to prevent deflation, which is the same as ‘causing inflation.’

A problem here is they believe that inflation is caused by rising inflation expectations, and not aggregate demand per se. That is, rising demand per se doesn’t cause inflation until that demand starts to drive inflation expectations.

Until this confused theory of inflation is discarded policy will continue to be confused as well.

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation.

Correct, which also means the policy failed to generate the desired results.

We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.


The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

How about an obligation to support a sufficient fiscal adjustment to eliminate the output gap rather than supporting deficit reduction?