Federal Reserve Chairman Ben Bernanke testified this morning in front of the House Financial Services Committee. Reuters has a nice, brisk summary of his main responses to questioning from members of Congress. There were two very interesting exchanges, resulting in some cryptic replies from Big Ben. Here's the first, on interest rates, which the Fed wants to keep as low as possible through 2014:
It is arguable that interest rates are too high, that they are being constrained by the fact that interest rates can't go below zero. We have an economy where demand falls far short of the capacity of the economy to produce. We have an economy where the amount of investment in durable goods spending is far less than the capacity of the economy to produce. That suggests that interest rates in some sense should be lower rather than higher. We can't make interest rates lower, of course. (They) only can go down to zero. And again I would argue that a healthy economy with good returns is the best way to get returns to savers.
Bernanke is indirectly raising the issue here of negative interest rates, something that he says is impossible for the Fed, but that some economists argue isn't. Gregory Mankiw, who's hardly a wild-haired lefty (he worked in the George W. Bush administration), made the case in the New York Times back in early 2009. He walked through some complex scenarios whereby accepting an effective negative interest rate on an investment could be made acceptable — or if not, then at least an encouragement to spend money rather than save it.
But then he brought up the "I" word:
If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.
Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.
The Fed hasn't gone for a higher inflation target, however, which can generally be interpreted as the institution defending the position of creditors over debtors (higher inflation reduces the future value of debt); trying to prevent further deflation in the housing market; and giving consumers who have much less money to spend a break by not subjecting them to higher prices. This has all gone hand in hand with the Fed's rather loose monetary policy, by which Bernanke & Co. have flooded the system with money in order to provide needed liquidity to the financial system (which has been a glutton for cash ever since the bailouts in 2008-09). The risk there is that inflation will manifest itself — too much money will chase too few goods, in the old Econ 101 formulation — but so far that hasn't happened (but not according to Ron Paul's supporters). And that's probably because demand in the economy has been AWOL.
So Bernanke would like to shoot for negative rates, but figures that the Fed can't really do it. Another round of "quantitative easing" could push long- and medium-term bond yields down, which would act something like negative rates (the 10-year Treasury, for example, is now yielding below 2 percent). But in his testimony, while Bernanke said that QE1 and QE2 had helped lower unemployment, QE3 might not be in the offing. Again, the chairman wants to Congress to act to provide a fiscal solution. That means higher taxes, spending cuts, or a combination of both.
The second thing that Bernanke addressed that was quite intriguing was the question of principal reductions on mortgages that are underwater:
The Fed has no official position on principal reduction and we were careful not to make explicit recommendations, precisely because we thought that was a congressional prerogative to make those determinations. We tried to provide a balanced analysis of principal reduction. I think it's a complex subject. It's not that we disagree on the goals, we want to reduce foreclosures and delinquencies, we want to help people who want to move to be able to do that, but there are often a number of alternatives in different situations. For example, if the idea is just to be able to move, then a short sale or deed-in-lieu might be the most effective way to do it.
Chairman Ben at his triangulating best! Principal reductions are anathema to the banks, which are ramping up the pace of foreclosures. Leaving the door open for shorts sales, however, is a good sign that the Fed wants to support principal reductions by another means. A short sale doesn't allow the homeowner to stay in the house, but it avoids foreclosure by compelling the lender to act on what amounts to a writedown: The homeowner owes $300,000, but the bank will take $250,000.
Overall, Bernanke seemed to be engaged in a bit of election year stalling, arguing that keeping the recovery going is now up to Congress. He can get away with this because unemployment is falling faster than many expected it would; and because the GDP grew at a surprising 3 percent in the fourth quarter of 2011. The economy is picking up steam and could sustain itself, absent a shock (from, say a Greek debt default) in 2012.
It's a convenient position, given that a good chunk of Congress is up for re-election in November. Of course, the stock market was hoping for a signal that QE3 might be on the way. And that's why we're seeing a pullback from yesterday's 13,000 Dow. A slight pullback. But a pullback, nonetheless.