Bernanke’s seven-percent solution

June 20, 2013

 

Federal Reserve Chairman Ben Bernanke has a problem: how to wean markets from dependence on central bank stimulus. On Wednesday Bernanke did what some of his most dovish colleagues have urged for months. He laid out a clear path for how and when the Fed will bring its third round of bond-buying to a close.

It doesn’t take a master detective to figure out his solution – 7 percent.

“If the incoming data are broadly consistent with this forecast, the committee currently anticipates that it will be appropriate to moderate the monthly pace of purchases later this year, and if the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year,” Bernanke said in a press conference following the Fed’s two-day policy-setting meeting.

“In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains.”

Bernanke’s seven-percent solution has not elicited from markets the same “long sigh of satisfaction” that Sherlock Holmes emitted after shooting up in “The Sign of Four.”

Far from it: stocks tanked and borrowing costs – as measured by yields on U.S. Treasuries – soared.

And yet, it’s worthwhile to bear in mind the seven-percent solution of another Fed policymaker, not so long ago.

“I believe we should adopt an explicit state-contingent policy rule that commits the Fed to providing accommodation at least as long as the unemployment rate remains above 7 percent and the outlook for inflation over the medium term is under 3 percent,” Chicago Fed President Charles Evans said last September, less than two weeks after the Fed launched the round of bond-buying stimulus that Bernanke has now signaled will likely end next year.  Shortly afterwards, Evans had lowered that 7 percent unemployment threshold to 6.5 percent, and limited his tolerance for inflation to 2.5 percent – and the Fed adopted the plan in December.

In other words: just eight months ago, one of the Fed’s arguably most influential policymakers was proposing 7-percent unemployment as an acceptable condition for raising rates. Now, the Fed’s unarguably most-influential policymaker says that 7-percent unemployment is where stimulus ends, not where rate hikes begin. Indeed, Bernanke made very clear the Fed could well defer rate hikes beyond the 6.5 percent marker.

“A decline in the unemployment rate to 6.5 percent would not lead automatically to an increase in the federal funds rate target but rather would indicate only that it was appropriate for the committee to consider whether the broader economic outlook justified such an increase,” Bernanke said. “All else equal, the more subdued the outlook for inflation at that time, the more patient the committee would likely be in making that assessment.”

So where does that leave rate policy? As Bank of the West economist Scott Anderson pointed out yesterday, only four Fed officials now believe a rate hike could come before 2015, compared with five just a few months ago. Those forecasts, he said, are “dovish for (a) long delay in rate hikes.”

And even if the Fed begins to reduce its $85 billion in monthly bond purchases in September, as more economists now believe it will, the very heft of the Fed’s $3 trillion-plus balance sheet will, Fed officials say, continue to push down on long-term borrowing costs.

Bernanke’s seven-percent solution still offers the economy quite of bit of stimulus, for quite a long time.

As the master consulting detective said of his choice of pharmaceutical upper, “It is cocaine,” he said, “a seven-per-cent solution. Would you care to try it?”

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