Bernanke sets major challenges for his successor
Now comes the hard part. Fed Chairman Ben Bernanke’s announcement that if the conditions are right he will wean the U.S. economy off quantitative easing within a year has already caused consternation in the stock market. Pumping money into the system by buying back government bonds at the rate of $85 billion a month has lately done little good, which is a persuasive reason to wind it down. But getting from here to there without incident is not going to be easy. It was simpler for Howard Hughes to land his gargantuan super-plane, the Spruce Goose.
Flooding the economy with easy money was meant to encourage businesses to borrow and invest. Instead, banks and businesses have ended up hoarding cash, waiting for a recovery to start before they take the plunge. Or the surplus money has been parked in stocks, lifting the market to an unprecedented, unsustainable high. That is what happens when you have a one-trick economic policy, dickering with the money supply and little else. As Keynes liked to say, you can’t get fat by buying a bigger belt. But stopping the flow of cheap money and hinting at an eventual increase in interest rates has consequences and they may be uncomfortable.
The first to get the jitters is the stock market. Even before Bernanke’s announcement, his previous hint that QE would be “tapered” sent a shiver through Wall Street. Now that he is turning off the juice for good, there is general trepidation. The eventual rise in interest rates is making the real estate market nervous, too, which is troublesome as home purchases are driving the still fragile recovery. On the other hand, there is no better time to buy a home. Mortgages will never be as cheap again, unless there is another slump-inducing financial meltdown, so now is the time to buy, or to refinance while interest rates are on the floor. And as the Fed withdraws from the government bonds market, yields are going to soar.
To ensure a smooth landing, Bernanke must be careful to ease his foot off the gas without letting inflation rip. Sound money economists have been issuing jeremiads since QE started, warning of a boom in prices that never came. Though it may be heresy to say so (ever since Paul Volcker, Bernanke’s predecessor at the Fed, deliberately provoked a recession to purge hyper-inflation from the system), a little inflation can be useful. Flat or falling prices are a disincentive to businesses, which need prices to rise — a little, but not too much — to turn a decent profit.
Even the hint of higher interest rates drives the dollar ever higher. As long as the euro zone remains in trouble, money flows into dollars as international traders’ safe haven. This is likely to continue, as the austerity regime imposed by Germany on its Mediterranean neighbors will last a decade or more. But a further increase in the dollar price is not what hard-pressed American exporters need to ensure their products and services look good compared to our trading rivals, who benefit above all from cheaper labor costs. An even stronger dollar also makes imports cheaper, leading to a widening trade deficit, meaning America is not paying its way in the world.
There were some important conditions in Bernanke’s statement which the market, ever eager to use every scrap of new information to turn a penny, has flatly ignored. In fact, the decision to halt the QE program has not yet been made by the Fed board. Bernanke was careful to say QE would end only if growth picked up, if inflation moves closer to its 2 percent target, and if unemployment continues to drop below 6.5 percent. That’s a lot of ifs. But the timetable he set for the abandonment of QE if all his conditions are met is surprisingly quick, starting by the end of the year and winding up by the middle of next.
That timetable does not take account of perhaps the most important factor of all: who will be in charge of the Fed once Bernanke leaves. His second term as Fed chairman ends in January and he has let slip he is no Franklin Roosevelt. He does not hanker after a third term. The president confirmed to Charlie Rose this week that Bernanke has “already stayed a lot longer than he wanted or he was supposed to.” So the choice of who to succeed him is a pivotal decision, not just for the health of the American economy but for the world economy, too.
When Congress is divided, as it looks likely to remain after next year’s midterms, the Federal Reserve is the only instrument of economic policy. And with Europe in the doldrums for the foreseeable future, America is left, as it has been so many times before, to tow the world out of the ditch. As we slowly recover from the worst recession in 80 years, the job specification for Bernanke’s job has altered. We used to need a steady hand on the tiller. Now more than ever we will need a resourceful, ingenious, politically adept, strong willed, articulate steward of the world’s recovery.
The first grisly task of the new man or woman will be to win confirmation from the Senate. For many who get to ask the questions, the Fed chairman hearings will be a golden chance to show off their conservative economic credentials and pander to those whose faith-based economics leads them to believe America can operate without a government. What is not on offer come January is the end of the Fed guiding economic policy. Those who believe government can abandon the management of the economy are living in their dreams.
What Bernanke made clear in his statement is that the new chairman’s real options are minimal. Everyone now agrees that QE, whether good or bad, should be wound down. Getting the pace wrong, too fast or too slow, will hamper the recovery. The next Fed chairman must phase out QE while encouraging growth, curbing inflation, and fostering employment. What is needed now is a new face at the Fed who can negotiate the hazards and lead America back to prosperity.
Nicholas Wapshott is the author of Keynes Hayek: The Clash That Defined Modern Economics. Read extracts here.
PHOTO: Traders watch as Federal Reserve Chairman Ben Bernanke is seen on television during a news conference, on the floor at the New York Stock Exchange, June 19, 2013. REUTERS/Brendan McDermid