What's the range on Bernanke's binoculars?

Ben Bernanke's testimony to Congress acknowledged the risk of keeping rates low for too long, but with unemployment and inflation well short of Fed targets it's still a case of 'wait and see'.

Ultra-easy monetary policy will remain in place in the US for some time to come, although there are risks to the economy if policy is kept loose for too long.

Chairman of the US Federal Reserve, Ben Bernanke, gave his testimony to the Joint Economics Committee of Congress this morning, Australian time, in which he indicated that the US economy remains in a sub-optimal position with an unemployment rate that is too high and it is being hampered by the contractionary effects of government spending cuts.

Easy monetary policy remains at the forefront of Bernanke’s plans with him saying, “a premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

At times, Bernanke was defensive. When questioned about the unorthodox application of monetary policy over the past few years, Bernanke said that monetary policy is providing “significant benefits” to the economy.

In late 2008, the Federal Reserve cut interest rates to near zero and in the last few years it has engaged in a total of several trillion dollars of quantitative easing or buying of bonds as it has worked to keep benchmark interest rates low, mainly for the benefit of corporate borrowers.

In his Congressional testimony, the main concerns for Bernanke returned time and again to high unemployment and risks that inflation falls too much under the weight of the significant spare capacity in the economy.

That said, Bernanke acknowledged the risks of having policy at such a stimulatory setting saying, “a long period of low interest rates has costs and risks” and he contemplated “the possibility that very low interest rates, if maintained too long, could undermine financial stability.”

Despite the broad-based dovishness through the bulk of his testimony, it appears this comment was the focus of market attention with stocks and commodity prices falling and bond yields rising, with the 10-year bond yield above 2 per cent.

For now, Bernanke judges the risks to the economy from policy being too loose for too long to be less important than the benefits to the economy from keeping policy easy until the recovery gets traction.

When asked about what conditions were needed to end the monetary stimulus and when that may occur, Bernanke humbly noted “It’s dependent on the data. If the outlook for the labour market improves, we would respond to that.”

Asked if the $US85 billion per month of QE could start to be scaled back “before Labor Day” (early September), Bernanke refreshingly said, “I don’t know”. 

In other words, the Fed is like the rest of us and will be swayed by new information as it emerges. In simple terms and perhaps something of a truism, it will keep monetary policy easy if the economy remains soft, and it will start to scale back on easy policy if economic conditions improve.

The background to Bernanke’s comments is one where the US economy continues to outperform its G7 peers, although the recovery of the last few years has been moderate at best and the more recent data shows that the growth momentum could be stalling. This stalling means annual GDP growth hovering in a 2 to 2.5 per cent range, rather than sustaining a push to 3 per cent or more.

While jobs are being created at a reasonable pace, it is only the drop in workforce participation that is pushing the unemployment rate lower. In other words, there are estimates that suggest there is almost as much spare capacity in the US labour market now as there was in the depths of the banking and economic crisis.

In all of this, inflation remains very low, too low in fact for the Fed which has an informal target of 2 per cent.

In the end, the US economy needs continued monetary policy stimulus. Bernanke made that abundantly clear in his testimony and he will keep delivering that stimulus until he sees unemployment near 6.5 per cent and/or inflation moving up towards 2 per cent. Neither of these conditions look likely in the next year, which means the world will continue to be flooded with easy liquidity with the US contributing mightily to that position.

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