The financial markets seem determined to interpret today’s statement by the Fed chairman in a dovish light, but a careful reading of his words does not support that point of view. True, Mr Bernanke outlined the possible ways in which monetary policy might be eased further if recent economic weakness should prove more persistent than expected. But he gave equal weight to the possibility that “the economy could evolve in a way that would warrant less-accommodative policy”.
There was no hint in the text about which of these outcomes he considered the more likely. We already knew from yesterday’s FOMC minutes for the June meeting that the committee is split about the likely evolution of policy, and we were waiting to see today whether the chairman would throw his weight behind either the doves or the hawks. He failed to do either.
Mr Bernanke’s description of the economic background was almost exactly the same as he offered after the June meeting. Economic activity was described as weaker than expected, and not all of that weakness was attributed to temporary factors. In his central view, growth would rebound in the second half of the year, but there was considerable emphasis on the continuing weakness of the labour market. Meanwhile, on inflation, some of the recent rise was also attributed to temporary factors, but the entire emphasis was on the headline rate, which he said had been running at over 4 per cent so far this year. There was no mention whatsoever of the much lower core inflation rate, a previous favourite of the chairman’s.
In other words, his overall message was that the economy might be undesirably weak, but that inflation was too high for the Fed to be able to respond to that weakness. That is the main point which we should all take from today’s evidence: no imminent change in policy is likely.
In the section on possible policy easing in the future, Mr Bernanke made it plain that this
would only apply if economic weakness proved more persistent than expected, and if deflationary risks reemerged. Note that economic weakness alone would not be sufficient. That is the key difference, in his mind, between now and last year. This year, there is no deflationary threat, and therefore no reason to contemplate further unconventional easing. The Fed Chairman has now said this so many times that the markets might one day start to pay attention.
Nor did he necessarily promise a full dose of QE3, even if the economy should weaken further, and deflation risks should reemerge. His check list of possible easing measures included all of those he has mentioned before. But many of them would have very little effect. For example, with the markets already expecting the federal funds rate to stay at zero for most of next year, would it really make much difference if the Fed formally committed itself to hold rates at zero for a longer period? Would a cut in the rate paid by the Fed on reserve deposits held by the banks, from the current 25 basis points, really induce them to lend more? And would it matter much if the Fed increased the average maturity of its security holdings? On all counts, it seems very doubtful.
Why is the Fed chairman apparently so reluctant to take further measures to stimulate demand, when he views the outlook for unemployment with considerable pessimism? In the short term, the rise in inflation explains this, and it is hard to blame him for that. But, in the longer term, he may be having some doubts about the extent to which structural unemployment has risen.