Dear Mr. Chairman:
You were the toast of Wall Street as equities hit another all-time high on Thursday. Immediately after your speech at the National Bureau of Economic Research the previous evening suggesting that the U.S. economy needed further monetary stimulus, Asian equities took off and the dollar plunged. U.S. equities followed upward from the opening bell on Thursday. It is impressive that while you had this electrifying impact on global markets, the release of the Fed minutes just a couple of hours before your speech was no market mover. The minutes of the June meeting suggested that you and other Federal Reserve officials were split on when the purchase of bonds — popularly known as quantitative easing, or QE — should be wound down. The ho-hum discussion in the minutes left equities flat at the end of Wednesday.
Your responses following the speech were widely considered “dovish” and reversed the impact that you had in responding to a question posed by the Congressional Joint Economic Committee on May 22: Is it conceivable that you could slow bond purchases as early as Labor Day? You said the process was data-dependent but that the scale of purchases could be reduced “in the next few meetings.” That tanked the surging stock market and pushed bond yields higher. In particular, the 30-year fixed mortgage rate rose by about 1 percentage point in the aftermath of your appearance. The chart below, providing Bankrate.com’s U.S. mortgage 30-year fixed rate, shows how the trend had been downward in April but has risen sharply since then.
The speech last Thursday lifted equities to new highs, but the bond market has not returned to old levels. Despite a mini-rally in Treasuries late in the week, bond investors are confused about your intentions. They are certainly less euphoric than equity investors, believing there may be losses ahead as stocks continue to rise. And let us not forget another major concern — that the higher mortgage rates may already have done damage and the negative impact on the economy may continue into the second half of the year. The unexpected 16,000 increase in jobless claims in the latest week to the 360,000 level, a two-month high, also contributed to concerns of a slowdown.
If all of this appears confusing, Mr. Chairman, that also describes how a number of market players feel now. I thought I would take this opportunity to raise a few questions, both theoretical and market-oriented, on the conduct of monetary policy.
(1) What is the timing of an exit from QE? — In the text prepared ahead of your May 22 appearance before Congress, you noted that a premature tightening of monetary policy could cause interest rates to rise. The “substantial risk,” you noted, is of “slowing or ending the economic recovery.” Yet, in answering a question posed by Rep. Kevin Brady about the timing of a QE exit, you seemed to be more concerned about market distortions resulting from bond purchases and show a greater interest in slowing them. Which is the true “Bernanke view,” the one expressing a need for stimulus or the one concerned about QE-created market distortions? Or is it somewhere in between those positions? I recall that several of your colleagues, doves and hawks alike, rushed to the media in the weeks following your congressional appearance to stress that a “tapering” of bond purchases was not imminent. Clearly, you and your Fed colleagues were shocked by the extent of adverse reaction in the bond market and went into damage control mode.
Since “openness” and “forward guidance” are said to be the hallmarks of your Fed, how can the market reconcile the contradictory messages of the past two months?
(2) Who speaks for the Fed? — Even as the market was feeling good about the continuation of Fed support for equities, Charles Plosser, president of the Federal Reserve Bank of Philadelphia, publicly expressed his view on Friday that tapering of bond purchases should begin in September. Is it wise for various members of the Federal Open Market Committee to express their disagreements in public? Is that also part of the “forward guidance” process? Is it not more akin to planting “forward confusion,” and does it not increase market volatility? An increase in volatility is not in the economy’s interest, is it, since it adds to the uncertainty in making investment decisions?
(3) Has QE been effective? — I was fully supportive of the introduction of QE in the aftermath of the Lehman Brothers failure in September 2008. With the global economy collapsing and global liquidity imploding, it was time to try extraordinary monetary measures, especially since you had already lowered the Federal Funds rate to near-zero levels. However, the economic recovery began in July 2009, according to the NBER, and QE is nearing its fifth birthday. How did an emergency measure become an everyday measure? Since markets seem to be addicted to QE, how would you react if another crisis hit? By increasing bond buying from the current $85 billion per month to $100 billion? $150 billion? Doesn’t the patient become resistant to antibiotics and require higher and higher doses with unknown side effects?
(4) Do you fully understand QE long-term impact? — The Fed’s balance sheet is forecast to quintuple by the end of this year from roughly $800 billion just prior to the 2008 crisis. As a student of monetary history, you know there is no precedent for such a massive expansion in the central bank’s assets. Consequently, there is no empirical evidence on what the surge in the balance sheet will do to relative valuations. For instance, even Americans who are close to retirement are being virtually forced to invest in risky assets because money market funds are yielding zero. Could a pension fund crisis arise if higher-yielding assets go into a dive? To cite another result of your policy, housing is booming again on the back of low interest rates. Would the Fed be setting the housing market up for a bubble, as was the case in 2006 and 2007?
(5) The FedaEUR(TM)s stated objectives — Unlike the European Central Bank, which was established with the control of inflation as its sole policy objective, the Federal Reserve has worked with two targets — inflation management and the creation of output and employment. It is indeed laudable to have both objectives in mind and, at times, to implement trade-offs between them based on which need is more pressing. However, you are well aware that boosting equity prices is not, and has never been, a policy objective of the U.S. central bank. I know, Mr. Chairman, that you and many other economists believe in the “wealth effect” of rising equity prices and its power to increase consumption spending and economic growth. However, your most recent speech underscored the belief that the economy still needs the stimulus of QE — more than four years after its introduction. Why has the much-touted wealth effect not set the economy on a faster growth path?
When the patient does not respond well to medication, might it be time to change the treatment rather than administer more of the same? Structural reforms such as the introduction of vocational training, employment tax credits and government subsidies to keep workers employed (rather than just benefits for those laid off) could be the answer to the persistent unemployment malaise. However, such structural shifts have not been a major element of policy in the years following the crisis.
I would conclude, Mr. Chairman, by commending you for ably administering emergency measures in the fall of 2008 and keeping the global economy going. On the other hand, you cannot have a child ride a bike with training wheels forever. It is time to take them off.
President, Sri-Kumar Global Strategies, Inc.
Komal Sri-Kumar is a Milken Institute Senior Fellow.