Federal Reserve

Learning from history

US Federal Reserve chief Ben Bernanke is making bold fiscal policy to avoid the errors of Japan's crash and the Great Depression

PUBLISHED : Friday, 14 December, 2012, 12:00am
UPDATED : Monday, 30 May, 2016, 2:05pm

United States Federal Reserve chairman Ben Bernanke has moved the central bank further into uncharted policy territory in combating joblessness by tying the bank's interest rate outlook to unemployment and inflation, while committing its balance sheet to an even faster expansion.

The actions on the eve of the Fed's centenary year underscore Bernanke's hallmark commitment to experimentation and forceful action, derived in part from his research showing too little monetary stimulus produced large economic costs for the US in the 1930s and for Japan in the 1990s.

He called the current state of the labour market, with unemployment at 7.7 per cent, "an enormous waste of human and economic potential" and said the benefits of more bond buying outweighed the potential risks, including stoking inflation.

"Bernanke is pulling out all the stops to kick this economy back into a higher gear," said Chris Rupkey, the chief financial economist at Bank of Tokyo-Mitsubishi UFJ. "They are buying everything in sight - treasuries, mortgage-backed securities - and will keep rates low until everyone who wants a job has one."

Bonds fell as news broke of potential higher inflation, after policymakers boosted their main stimulus tool by adding US$45 billion of monthly treasury purchases to an existing programme to buy US$40 billion in mortgage debt a month. That decision puts the Fed's US$2.86 trillion balance sheet on track to reach almost US$4 trillion by the end of next year.

Central bankers have now for the first time linked their interest rate outlook to economic thresholds, saying rates will stay low "at least as long" as unemployment remains above 6.5 per cent and if the Fed projects inflation of no more than 2.5 per cent one or two years in the future.

Fed officials do not see joblessness falling near that goal until 2015. Interest rates are expected to stay low until at least the middle of 2015.

The adoption of thresholds was urged in September by Charles Evans, president of the Chicago Fed, who said the central bank should "add very significant amounts of policy accommodation" to bring down unemployment, even at the risk of a temporary increase in inflation.

A year later, the idea was backed by Minneapolis Fed president Narayana Kocherlakota, who had earlier criticised the Fed's easing policies.

Fed vice-chairman Janet Yellen and the Boston Fed's Eric Rosengren last month backed the concept. Last month, Evans spelled out the numerical benchmarks that were adopted on Wednesday.

"The Fed is all in," said Diane Swonk, the chief economist for Mesirow Financial. "They are absolutely committed to averting the mistakes of the Japanese and of the Great Depression. They will not stop too soon. He is willing to take the risk of unintended consequences."

The additional treasury purchases will follow the expiration at the end of the month of Operation Twist, in which the central bank each month has swapped about US$45 billion of short-term treasuries for an equal amount of long-term debt.

Bernanke, who lowered the benchmark interest rate almost to zero four years ago, said the Fed's "ability to provide additional accommodation is not unlimited", which was "an argument for being a little bit more aggressive now".

As a Princeton University professor in January 2000, Bernanke presented a paper called "Japanese monetary policy: A case of self-induced paralysis?" In it, he criticised monetary authorities' unwillingness to experiment, "to try anything that isn't absolutely guaranteed to work".

In slumps, policymakers need "Rooseveltian resolve", he wrote, which he described as a "willingness to be aggressive and to experiment - in short, to do whatever was necessary to get the country moving again".

Bernanke shunned orthodoxy as the global credit crisis unfolded, giving out more than US$2 trillion in emergency aid through six loan programmes, currency swaps with other central banks and the rescues of Wall Street investment bank Bear Stearns and big insurer American International Group.

The Federal Open Market Committee on Wednesday also lowered its forecasts for US economic growth next year to 2.3 per cent from 3 per cent, compared with 2.5 per cent to 3 per cent in September. The average pace of growth for the decade to 2007 was 3 per cent.