Ben Bernanke is worried — and perhaps we should be, too.
As chairman of the Federal Reserve from 2006 to 2014, it was Bernanke, along with others, who prevented the worst recession since World War II from becoming the Great Depression 2.0. Now he fears that, should another sharp recession occur, the Fed won’t be able to contain it.
Traditionally, the Fed has sought to influence the economy by changing short-term interest rates. If a recession looms, the Fed cuts the “fed funds” rate to stimulate demand. If the danger is inflation, the Fed raises the rate to relieve wage and price pressures. Changes in the fed funds rate are assumed to nudge rates on mortgages, corporate bonds and Treasury securities in the same direction.
But there’s a practical limit to this approach: Once the Fed has cut the rate to zero, it can’t do much more. If the recession is deep, it may outlast the Fed’s therapy. To many economists, failure portends dire consequences: deflation (falling prices). Too little demand chases too much supply.
Deflation was rampant in the Great Depression. From 1929 to 1933, retail prices dropped 24 percent. At first glance, deflation seems a boon; consumers’ buying power increases. But beyond these modest benefits, stubborn deflation threatens a vicious circle of economic decline. Consumers delay big purchases because they think prices will drop. Debt burdens become greater, as borrowers must repay in more expensive dollars. Unemployment rises, and the Fed is helpless.
To avoid this trap, Bernanke — while Fed chairman — adopted what’s called “unconventional monetary policy.” First, the Fed flooded the economy with money by buying an estimated $3.7 trillion worth of mortgage bonds and U.S. Treasury securities; the aim was to reduce long-term interest rates further. And second, the Fed gave “forward guidance” — in effect, a nonlegal commitment — that short-term interest rates would stay low for a long period.
In a paper presented recently at the Peterson Institute for International Economics, a Washington think tank, Bernanke judged that these policies — to some extent — had helped end the Great Recession and sustain the recovery. What troubles him now is the possibility that the same policies won’t work in a severe recession or financial crisis in the future.
We already live in a “low-inflation, low-interest-rate environment,” he tells us. Consumer price inflation has been running below 2 percent annually, the Fed’s official target, for most of nine years. The fed funds interest rate is now at a peak of 1.25 percent. Rates on 10-year Treasury securities are 2.3 percent. These low levels occur despite eight years of recovery and an unemployment rate of 4.2 percent.
Just why inflation and interest rates are so low is debated by economists. Theories abound: The psychological hangover of the Great Recession causes companies to restrain wage and price increases; global competition and new technologies reduce upward pressures on wages and prices; an aging society saves more than a younger nation.
But whatever the causes, already low inflation and interest rates — which are pleasurable while the economy is healthy — make it harder for the Fed to rescue a sickly economy that is suddenly sliding into a steep slump.
Consider a comparison between then and now.
In 2007 and 2008, when the economy was weakening, the Fed cut the fed funds rate 5.25 percentage points to near zero in a little over a year. Now a plausible cut would be 1 to 3 percentage points (the higher figure assumes the Fed continues raising the fed funds rate from its present extremely low levels). The same math undermines another round of “unconventional” monetary policies.
Then there’s deflation. A harsh recession could depress prices, threatening a downward spiral of spending and business investment.
In his paper, Bernanke makes a proposal to allow the Fed to escape this predicament. His plan is complicated and, in practice, would involve the Fed throwing more money at a faltering economy in the hope that it would recover and be stabilized. (The complexities of Bernanke’s plan extend even to its name, “temporary price-level targeting.”) There are other plans on the table; whether the Fed will adopt any of them is an open question.
Still, Bernanke’s plan and accompanying analysis represent a useful addition to the ongoing debate over economic policy. There certainly will be another recession, though we can’t know when or how severe. Bernanke plausibly worries that we won’t be ready. If not his proposal, then whose and why? These are good questions without good answers. We may be reaching the limits of the Fed’s power over the economy.
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