Tuesday, December 15, 2009

Bernanke fires back with answers to Senator Bunning's questions

Senator Bunning has received responses to 70 questions posed to the Fed Chairman recently at his reconfirmation hearing. This is a quick read, and I recommend it. The questions cover a wide array of topics. Those that surface often concern inflation, AIG, the price of gold and the Fed's role in the financial crisis, to name a few. Here are some sample questions and replies:

6. Time and energy in macroeconomic analysis is spent attempting to measure business and consumer confidence. Confidence measures are part of macroeconomic forecasting and directly impact monetary policy decisions. Likewise, certain market movements reflect investor confidence or lack of confidence. Gold is at an all-time high because investors have lost confidence in policymakers' handling of fiat currencies. How is the Fed incorporating this market information into its analytical framework? Does the lack of confidence in fiat currencies have the potential to impact monetary policy?

Bernanke: Gold is used for many purposes, including as a reserve asset, as an investment, and for use in electronics, automobiles, and jewelry. Thus, fluctuations in the price of gold can reflect changes in demand associated with any of these uses, as well as changes in supply. In monitoring the price of gold, the Federal Reserve must attempt to interpret which of these factors is responsible for its fluctuations at any point in time. One of the ways we do this is by consulting other indicators of market sentiment. A number of measures of expected future inflation in the United States, including measures taken from inflation-protected bonds and surveys of consumers and professional forecasters, have been well contained. Accordingly, increases in the price of gold do not appear to reflect increases in the expected future of U.S. inflation.

43. The importance you place on the output gap is well known. You have often cited “excess slack” in the economy to justify loose monetary policy, arguing that a large output gap lowers the risk of inflation. But economists such as Allan Meltzer have noted that there are "lots of examples of countries with underutilized resources and high inflation. Brazil in the 1970s and 1980s." Moreover, in a new paper dated December 2009 and titled "Has the Recent Real Estate Bubble Biased the Output Gap?", researchers at the Federal Reserve Bank of St. Louis state “Because this (predicted) output gap is so large, several analysts have concluded that monetary policy can remain very accommodative without fear of inflationary repercussions. We argue instead that standard output gap measures may be severely biased by the bubble in real estate prices that, according to many, started around 2002 and burst in 2007.” They conclude with a warning: "We offer a word of caution to policymakers: Policies based on point estimates of the output gap may not rest on solid ground." Please comment on 1) Allan Meltzer's point and 2) the St. Louis Fed's research paper. Why do you continue to put such a high priority on the output gap?

Bernanke: I do find the evidence compelling that resource slack, as measured by an output or unemployment gap, is one factor that influences inflation. But it is not the only such factor, and Allan Meltzer is correct that there have been examples of underutilized resources coinciding with high or rising inflation. This was the case in the United States in the 1970s, for example, when large increases in the price of imported oil both raised inflation and held down production.

Furthermore, estimates of the output gap are inherently uncertain, and I agree that it is important to keep that uncertainty in mind when we make decisions about monetary policy. Some estimates, such as the one you cite from researchers at the St. Louis Fed, suggest that the output gap is not large at present. However, the bulk of the evidence indicates that resource slack is now substantial, as evidenced by an unemployment rate of 10 percent and a rate of manufacturing capacity utilization of only 68 percent--lower than seen at the trough of every postwar recession prior to the current one. Thus, I continue to expect slack resources, together with the stability of inflation expectations, to contribute to the maintenance of low inflation in the period ahead.

8. What are the limits on the ability of the Fed to engage in quantitative easing?

Bernanke: A central bank engages in quantitative easing when it purchases large quantities of securities, paying for them with newly created bank reserve deposits, to increase the supply of bank reserves well beyond the level necessary to drive very short-term interbank interest rates to zero.

The Federal Reserve’s large-scale asset purchases have been intended primarily to improve conditions in private credit markets, such as mortgage markets; the increase in the quantity of reserves is largely a byproduct of these actions. In any case, while large-scale asset purchases can help support financial market functioning and the availability of credit, and thus economic recovery, excessive expansion of bank reserves could result in rising inflation pressures.

Congress has given the Federal Reserve a dual mandate to promote maximum employment and stable prices. That mandate appropriately gives the Federal Reserve flexibility to engage in quantitative easing to combat high unemployment and avoid deflation while requiring that it avoid quantitative easing that would be so large or prolonged that it could cause persistent inflation pressures.