Fed's capacity to stimulate economy is limited

Saturday, August 28, 2010

CONSIDER THE predicament of Ben S. Bernanke, chairman of the Federal Reserve Board. The world is looking to him for reassurance that the U.S. economy is not about to go into recession -- again -- despite many worrisome new statistics. Yet in a long-awaited speech at the Fed's annual conference in Jackson Hole, Wyo., on Friday, the most optimistic claim Mr. Bernanke could honestly make is that the economy is more likely than not to continue growing at about its current modest pace. Neither inflation nor deflation is a near-term threat -- it appears. And this necessarily equivocal forecasting came accompanied by Mr. Bernanke's admissions that the Fed's past predictions about growth, household spending and the U.S. trade balance did not pan out.

Small wonder that the chairman began his speech with an attempt to lower expectations: "Central bankers alone cannot solve the world's problems," he admonished. It's especially hard to solve them after you have already taken interest rates to near zero and bought a trillion dollars worth of mortgage-backed securities and other bonds. These extraordinary steps -- known as quantitative easing -- have left the Fed with few cards left to play. In fact, Mr. Bernanke had hoped to be well into the process of unwinding quantitative easing by now, rather than extending it.

Still, Mr. Bernanke pledged that the Fed would resume "unconventional measures" if the economic outlook gets "significantly" worse. Those might include adding substantial new securities to its balance sheet, cutting the interest rate it pays on bank reserves to stimulate lending, and even tweaking market psychology by modifying its pronouncements about how long it will keep rates near zero. It basically comes down to Mr. Bernanke's commitment to print as much money as it takes to prevent a deflationary collapse. But none of these measures would stimulate the economy dramatically, and each carries potential costs, as Mr. Bernanke acknowledged.

Markets have been conditioned to look to the Fed by recent history in which rate adjustments by both Mr. Bernanke and his predecessor, Alan Greenspan, seemed to rescue the economy from impending disaster. The Fed's inability this time to magically produce a wave of growth, even when abetted by fiscal stimulus, suggests that the United States faces a crisis that is structural rather than cyclical.

The answers lie not in kick-starting old engines of growth such as housing and consumer spending. Instead, the challenge is to identify and invest in new opportunities and equip the American people -- through education, tax reform and entitlement reform -- to take advantage of them. This is a much harder job, one that will require the concerted attention of public and private sector leaders, at federal and state levels, over many years. Mr. Bernanke can help by keeping the economy functioning in the meantime. But Fed policy is no substitute for a reshaping of the economy.

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