The biggest surprise out of the Federal Reserve’s blockbuster decision Wednesday to announce specific levels for unemployment and inflation that could trigger a policy change is this: That we all viewed it as a surprise.
After all, for five years running, the Fed under Chairman Ben S. Bernanke has had a remarkable track record of moving creatively, aggressively, and quickly to try to ease policy and get the U.S. economy on track — usually more creatively, more aggressively, and more quickly than those who spend their days watching the Fed thought possible.
Over the last two years, Bernanke and his colleagues at the Fed have been flummoxed that, years after the crisis and despite extraordinary interventions by the Fed, the U.S. economy has seemed stuck in a rut, unable to grow fast enough to accelerate back to full employment. Across Washington and at many of the world’s other central banks, there was a sense of fatalism: The economy has suffered a crushing blow. More stimulus — monetary, fiscal, whatever — won’t work. All we can do is sit on our hands and hope for the best.
“Printing money is not . . . simply manna from heaven,” Bank of England Governor Mervyn King said in a speech in October. “There are no shortcuts to the necessary adjustment in our economy. The problems in the world economy mean that we shall have to be patient.”
Bernanke, has, in effect, rejected that fatalism. He instead rolled up his sleeves and put his own considerable brainpower and that of hundreds of Fed economists into understanding why the Fed’s earlier stimulus hadn’t packed more punch, and whether a different approach might do the trick. He steered his colleagues on the Federal Open Market Committee through a debate that has lasted more than a year. Chicago Fed President Charles Evans first laid out in September 2011 the idea that has, in modified form, now become the rule of the monetary land.
Bernanke and the Federal Open Market Committee weighed the arguments of economists supporting “nominal GDP targeting,” but rejected a full-bore push in a direction that seemed to them risky and unworkable. But they took to heart some crucial insights from advocates of that approach, particularly around the importance in a central bank shaping expectations to influence the economy.
In particular, the Fed’s earlier efforts to ease policy -- such as by buying longer-term bonds with newly created money, as in 2010’s QE2, and by announcing the Fed expected short-term rates to stay low for two or three more years, as it did in 2011 -- may not do a whole lot if they don’t change the expectations of actors in the economy for what will happen in the future.
The particular approach that the Fed undertook Wednesday was rooted in the idea is that if investors, businesspeople, and consumers know that the Fed won’t tighten policy until either the unemployment crisis is well on its way to being solved or inflation seems on the verge of becoming a problem, the economy will better be able to heal. Borrowing costs will fall when the economy looks worse, helping buffer the effects of any bad news (such as a tumble off the fiscal cliff). The knowledge that the Fed is willing to let inflation go a bit above its normal 2 percent target as the economy returns to health gives businesses and consumers greater incentive to deploy cash rather than hoard it.
That’s the theory, anyway. We don’t really know how this policy will work out. Could signaling a willingness to abide a little bit of inflation lead to deeper fears of future inflation that leads to a counterproductive rise in longer-term interest rates? Will businesses and consumers react in ways that run contrary to the economic models? Could the zero interest rate policy (now in place for four years and counting) and a Fed balance sheet now set to grow at a pace of $85 billion a month (a result of the other leg of the FOMC’s policy announcement) create new financial bubbles?
We’ll find out over the months and years ahead. Bernanke made his career studying the errors of central bankers in the Great Depression and then in 1990s Japan, arguing consistently that more forceful monetary policy would have jolted those economies out of their troubled state. He has acted as if on a mission to avoid becoming one of those central bankers who were, in his view as an academic, culpable for unnecessary misery heaped upon their people.
Bernanke may have just over a year left in office, assuming President Obama appoints someone new to take over the Fed chairmanship in January 2014. Bernanke’s legacy will be one of constantly pushing the bounds of monetary policy to try to address the defining economic challenges of our age.
Whether economic historians of the future see that as a way of heaping praise or blame will depend only on the results.