The broad scope and open-ended nature of the Federal Reserve’s third round of quantitative easing (QE3) raises questions about exactly what Fed Chairman Ben Bernanke has in mind. Some insight, remarkably, emerges from a speech he gave in November 2002, when he was simply a Fed board member, to the National Economists Club in Washington. Taking his cue from fears at the time about a Japanese-style deflation, Bernanke laid out a path for monetary stimulus in an extreme situation, outlining non-traditional policy tools that have since become common. The speech also took comfort in the relative strengths of the U.S. economy compared with Japan’s. Perhaps the dissipation of those advantages contributed to Bernanke’s decision to pursue QE3 now.
The Fed chairman’s 10-year-old talk offers a remarkable forecasting device. It explained how, in an extreme situation, traditional monetary policy tools, even bringing short-term interest rates down to zero, might not produce enough stimulus, and it listed the “non-traditional” policies the Fed might employ: 1) purchasing longer-dated Treasury, agency, and mortgage-backed securities; 2) announcing an intention to keep short rates low for an extended period; and 3) injecting liquidity into financial markets by accepting corporate bonds, bank loans, commercial paper and mortgages, among other securities, as collateral for direct lending to banks. All these tools made appearances during the 2008-09 financial crisis and have lingered in its aftermath. A fourth technique Bernanke mentioned in 2002 involved purchasing the debt of foreign governments. The Fed has yet to do so, but it might if there is any further deterioration in Europe.
Behind all of these measures, Bernanke’s talk pointed to the growth of money and liquidity as the ultimate policy objective to get the economy moving and, in the specific context of his talk, to avoid deflation. He even alluded to running the “printing press” and the “electronic equivalent” to force funds into the economy and financial markets. For a while in this more recent period, that objective seemed to elude the Fed. Banks failed to lend, and money growth languished. But of late the chairman has gotten his looked-for responses. Federal Reserve statistics show the narrow M1 definition of money has grown at a robust rate of about 11% during the last 12 months and accelerated to about a 15.5% annual rate of advance over the past three months. The broader M2 definition of money expanded at a strong 6.3% rate during the last 12 months and held at a 6.5% annual rate of expansion over the last three months. Banks have begun to lend, too. Overall bank lending has expanded at an annual rate of about 3.5% during the past three months, with the critical commercial and industrial component growing at a 13.7% annual rate.
On this basis, Bernanke might easily have foregone QE3 or at the very least postponed it. But that same 10-year-old speech hints at why he made his bold move anyway. Back in 2002, Bernanke took comfort in important American advantages that would protect this economy from Japan’s deflation and its other problems. The American financial system, he noted, was much better capitalized than Japan’s, businesses and financial institutions had greater confidence, the U.S. economy was more flexible, and Washington had more fiscal options than Tokyo. But over the last decade, many of these advantages have dissipated. The U.S. financial system is less resilient and less well capitalized than it was. After years of stubbornly high unemployment and a corporate sector that timidly holds huge cash balances in lieu of hiring and expansion, the economy, too, shows less flexibility and resilience. And it is plain that American fiscal policy has fewer options now than it did then.
Such comparisons no doubt introduced a sense of urgency into the Fed’s decision to pursue QE3 now, despite other signs that might have counseled a less aggressive approach. Still, such influences and the decisions they have occasioned should in no way suggest that America will go down Japan’s path. Certainly the recent growth in money and lending offers a welcome distinction from the Japanese experience. Nor are there signs of deflation in the U.S. economy. Moreover, even Chairman Bernanke highlighted his confidence in the economy’s recovery by discussing the Fed’s ultimate need to unwind its remarkable policy measures. Underscoring that point still more, he has even outlined the risks should the Fed fail to take such remedial action. But for the time being, Bernanke’s worries about economic weakness have created a clear bias on the side of the bold actions, much as he outlined almost 10 years ago.
For Milton Ezrati’s analysis of Bernanke’s warnings about the risks involved in QE3, see Chairman Bernanke Tracks Risks. For more Ezrati takes on the U.S. economy, see An Improving Trade Picture and Don’t Get Carried Away by Housing Gains.