In a long and detailed paper, Bernanke forcefully argues that the Fed has the tools to protect the economy. All we need to do is adopt the measures deployed successfully during the financial crisis, he says.
For the moment, the Fed doesn't seem to have a problem. Inflation, interest rates and unemployment are all low. This seems ideal. It's where every Fed chairman would like to be.
The problem (potentially) arises if the economy falters or falls into a recession. The Fed’s usual weapon to combat slumps is to cut short-term interest rates — mainly the rate on fed funds, which are overnight loans among banks and other financial institutions. The more the Fed cuts, the bigger the “stimulus” to the economy.
The trouble is that there’s not much to cut. Because inflation is already low, so are short-term interest rates. The fed funds rate is now between 1.5 percent and 1.75 percent. By contrast, the fed funds rate was 5.25 percent before the last recession. The Fed had far more room to cut. (The problem afflicts many central banks. In an interview with the Financial Times, Mark Carney, the departing governor of the Bank of England, warned that many central banks have much less “ammunition” to fight a major recession.)
What more can the Fed do if it cuts the fed funds rate to zero?
The answer, Bernanke replies, is to resurrect the policies used in the financial crisis when the fed funds rate also dropped to almost zero.
There were two main policies: first, so-called quantitative easing — shortened by economists to “QE”; and second was “forward guidance.”
QE involved the Fed buying U.S. Treasury bonds with longer maturities — for example, 10 years. This drove down interest rates on these bonds and, presumably, the lower interest rates stimulated the economy by making it cheaper to borrow. In his paper, Bernanke cites studies that estimated the effect on long-term interest rates was about a 1 percentage point decline.
“Forward guidance” is a mind game. Fed officials pledge to keep interest rates low for an extended period (the amounts differ among proponents). Financial markets — that is, investors — would take their cues from the Fed. Interest rates would stay low, strengthening the recovery. That’s the argument.
Needless to say, this is a hugely complex and controversial subject. Bernanke concedes that there's room for disagreement but contends that the experience with these policies in the Great Recession warrants confidence that they can work again.
By his estimates, the adoption of QE and forward guidance would be the equivalent to a cut of 3 percentage points in the short-term rates. Forward guidance has “the potential to shift the public’s expectations in a way that” promotes recovery, he says. Combine that with a 2 percentage point cut in short-term rates, and the result is the equivalent of a 5 percentage point drop in short-term rates — more in line with historical experience.
Naturally, there’s a catch, one acknowledged and explained by Bernanke himself. To maintain a satisfactory stimulus requires that short-term rates be cut by at least 2 percentage points. But short-term rates (remember: now at 1.5 percent to 1.75 percent) are already lower than this crucial threshold for his plan to succeed. By his own assessment, the plan wouldn’t work now.
There’s also a larger problem. It involves trust and credibility. For the proposal to succeed, people have to understand generally what the Fed is trying to do and find it believable. This is possible, but it is by no means guaranteed. The recent history of the American economy is littered with examples of people and firms not doing what economists expected them to do. It comes with the territory.