By Dr. Lynn Reaser
Spending the last three days in Jackson Hole, Wyoming, at a conference of the world’s central bankers has given me new perspectives on the challenges and possible solutions facing us during the next decade.
U.S. Federal Reserve Board Chairman, Ben Bernanke, opened the conference on Friday morning, with comments on prospects for the United States in the year ahead. Various press reports appeared to have interpreted his comments in different ways. My reading of his remarks follows.
American economic growth and inflation have slowed but neither a retreat back to recession (the “double-dip” scenario) nor deflation appears as the most likely outcome. The Fed does have tools to deploy to counter these risks if necessary, but the solutions have their own costs and drawbacks.
The Chairman described four solutions. He summarily dismissed one of them—raising the Fed’s inflation target. The President of the European Central Bank, Jean-Claude Trichet, also criticized this solution in his remarks at lunch. Moving the inflation anchor away from 1.5% to 2.0% could impose losses on holders of debt and significantly elevate volatility in financial markets. Companies would be faced with new uncertainties regarding wage and price behavior.
One option for monetary policy could involve the additional purchase of Treasury or mortgage-backed securities, increasing the size of the Fed’s balance sheet beyond its current $2.3 trillion. Such purchases could, however, raise inflation fears and could make the Fed’s ultimate “exit” strategy and unwinding of its large security holdings even more difficult.
Another option would be to reduce the interest paid on banks’ excess reserves held with the Federal Reserve from the current level of 25 basis points (one-quarter percentage point) to zero to 10 basis points. The aim would be encourage banks to put their funds to more productive use than leaving them with no earnings power. The downside of this alternative would be the possible disruption to short-term money markets as interest rates moved to zero.
A third policy alternative would involve changing the language of the Fed’s policy intention to be more definitive as to how long the federal funds target might be maintained at its current zero to 25 basis point range. For example, one year could be specified. The downside of this solution is that it could limit the Fed’s ability to respond to changing economic conditions. Specifically, it could prevent monetary authorities from responding to any possible change in economic and inflation signals within that 12-month period.
In summary, it appears that the Federal Reserve will act if necessary to ward off deflation and/or a return to recession. The costs of the solutions, however, mean that such actions will only be taken if the negative evidence on the U.S. economy and its prospects appears convincing and compelling.