Mixed signals from economic data both at home and abroad have once again led the Federal Reserve to delay its long-anticipated interest rate increase. The backdrop is the Fed’s pegging of short-term interest rates to near zero for nearly seven years, along with its unprecedented balance sheet purchases of more than $3 trillion in securities. Former Fed Chairman Ben Bernanke credits these policies for helping to avoid a more serious depression in the wake of the 2008 financial crisis, as well as for the superior performance of the U.S. economy in comparison to Europe’s.
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Bernanke has recently argued that the Fed “saved the economy,” pointing to the superior superior performance of the U.S. economy versus that of Europe as prima facie evidence of the success of the Fed’s policies since the crisis of 2008. He also has ungraciously chided his critics, both those on the domestic front who expressed fears of inflation that has not (yet) materialized, and European critics of the Fed’s quantitative easing.
But comparisons to Europe aside, by U.S. standards the recovery has been very weak. Real GDP growth has averaged only 1.4 percent annual growth since the trough of the recession in 2009, compared to 2 percent over similar periods following the previous two recessions. In fact, this comparison understates how weak the recent performance has been, despite the Fed having its accelerator all the way to the floor since December 2008: The last recession was much deeper than the previous two, so a comparable recovery would have required stronger growth than in earlier expansions.
So how effective has monetary policy really been? Not very. Bernanke and other defenders of the Fed would argue the recovery would have been even more anemic without its help, but there is no way to know that. The reality is that the Fed years ago exhausted the potential of monetary policy to do anything other than prop up asset prices. Like an overprotective parent it has communicated a practically self-fulfilling but harmful message that the economy is not capable of recovery without the support of near zero interest rates. Hence the near panic at any hint, and the continual postponement, of a rate increase.
In fact, the opposite is likely true: As in Japan, where more than a decade of zero interest rates and fiscal stimulus failed to restore anything like normal growth, the U.S. economy would likely be better off now had both monetary and fiscal policy reverted to neutral and instead allowed the economy’s natural restorative forces unleash themselves.
Proponents of the Fed’s ZIRP (zero-interest rate policy) will quickly point out that the low inflation numbers in recent years belie any claim that policy has been too loose. In a sense they are right: Policy has not been as loose as interest rates suggest, because the Fed has been pushing forward on one lever (asset purchases) while pulling back on another (paying interest on bank reserves). With the economy’s mediocre fundamentals (those supply factors mentioned above), banks are happy to hold large reserves of cash, thus blunting the impact of the Fed’s enormous balance sheet increase.
Bernanke’s gloating about the lack of inflation is thus somewhat misplaced. The concern about losing control of inflation (in one direction or the other), has always been (or should have been), on the Fed’s ability to manage the transition back to normalcy, i.e. the unwinding of its balance sheet, the raising of interest rates, and the drawing down of bank reserves. The Fed may be able to manage all this, but so far it is just lots of rhetoric – it brags about the ability to do so while postponing actually doing it.
The Fed’s track record, moreover, on anticipating and managing major turning points has been anything but stellar. Who can forget Bernanke’s testimony in the spring of 2007 that “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained”? Or perhaps worse, the Fed’s declaring in early 2008 that no recession is in sight, and leaving its target interest rate at 5.25 percent all the way until that fateful September, notwithstanding the fact that a recession had already begun in the second half of 2007. A similar, albeit less dramatic, episode occurred in late 2000, when the Fed kept its policy rate at 6.5 percent, only to call an emergency meeting in early January 2001 to cut the rate, too late to stave off recession.
The point of these examples is not to criticize the Fed for forecasting inaccurately. Predicting the future course of the economy, especially around turning points, is notoriously difficult. Rather, it is to urge the Fed to show more humility, to know what it does not know. There is a recurring pattern of hubris: policy decisions that presume unwarranted confidence in both the direction of the economy and in the Fed’s ability to manage through unforeseen changes. The broader lesson is that the Fed has not demonstrated the ability to micro-manage business cycles. The transition away from ZIRP is long overdue, and while it may not be pleasant, postponing it will likely only make the eventual consequences more painful.