Ben S Bernanke: Five questions about the Federal Reserve and
monetary policy
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the Economic Club of Indiana, Indianapolis, Indiana, 1 October 2012.
* * *
Good afternoon. I am pleased to be able to join the Economic Club of Indiana for lunch
today. I note that the mission of the club is "to promote an interest in, and enlighten its
membership on, important governmental, economic and social issues." I hope my remarks
today will meet that standard. Before diving in, I'd like to thank my former colleague at the
White House, Al Hubbard, for helping to make this event possible. As the head of the
National Economic Council under President Bush, Al had the difficult task of making sure that
diverse perspectives on economic policy issues were given a fair hearing before
recommendations went to the President. Al had to be a combination of economist, political
guru, diplomat, and traffic cop, and he handled it with great skill.
My topic today is "Five Questions about the Federal Reserve and Monetary Policy." I have
used a question-and-answer format in talks before, and I know from much experience that
people are eager to know more about the Federal Reserve, what we do, and why we do it.
And that interest is even broader than one might think. I'm a baseball fan, and I was excited
to be invited to a recent batting practice of the playoff-bound Washington Nationals. I was
introduced to one of the team's star players, but before I could press my questions on some
fine points of baseball strategy, he asked, "So, what's the scoop on quantitative easing?" So,
for that player, for club members and guests here today, and for anyone else curious about
the Federal Reserve and monetary policy, I will ask and answer these five questions:
1. What are the Fed's objectives, and how is it trying to meet them?
2. What's the relationship between the Fed's monetary policy and the fiscal decisions
of the Administration and the Congress?
3. What is the risk that the Fed's accommodative monetary policy will lead to inflation?
4. How does the Fed's monetary policy affect savers and investors?
5. How is the Federal Reserve held accountable in our democratic society?
What are the Fed's objectives, and how is it trying to meet them?
The first question on my list concerns the Federal Reserve's objectives and the tools it has to
try to meet them.
As the nation's central bank, the Federal Reserve is charged with promoting a healthy
economy - broadly speaking, an economy with low unemployment, low and stable inflation,
and a financial system that meets the economy's needs for credit and other services and that
is not itself a source of instability. We pursue these goals through a variety of means.
Together with other federal supervisory agencies, we oversee banks and other financial
institutions. We monitor the financial system as a whole for possible risks to its stability. We
encourage financial and economic literacy, promote equal access to credit, and advance
local economic development by working with communities, nonprofit organizations, and
others around the country. We also provide some basic services to the financial sector - for
example, by processing payments and distributing currency and coin to banks.
But today I want to focus on a role that is particularly identified with the Federal Reserve
- the making of monetary policy. The goals of monetary policy - maximum employment and
price stability - are given to us by the Congress. These goals mean, basically, that we would
like to see as many Americans as possible who want jobs to have jobs, and that we aim to
keep the rate of increase in consumer prices low and stable.
In normal circumstances, the Federal Reserve implements monetary policy through its
influence on short-term interest rates, which in turn affect other interest rates and asset
prices.1 Generally, if economic weakness is the primary concern, the Fed acts to reduce
interest rates, which supports the economy by inducing businesses to invest more in new
capital goods and by leading households to spend more on houses, autos, and other goods
and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help
cool total demand and constrain inflationary pressures.
Following this standard approach, the Fed cut short-term interest rates rapidly during the
financial crisis, reducing them to nearly zero by the end of 2008 - a time when the economy
was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the
short-term interest rate could not be cut further, so our traditional policy tool for dealing with
economic weakness was no longer available. Yet, with unemployment soaring, the economy
and job market clearly needed more support. Central banks around the world found
themselves in a similar predicament. We asked ourselves, "What do we do now?"
To answer this question, we could draw on the experience of Japan, where short-term
interest rates have been near zero for many years, as well as a good deal of academic work.
Unable to reduce short-term interest rates further, we looked instead for ways to influence
longer-term interest rates, which remained well above zero. We reasoned that, as with
traditional monetary policy, bringing down longer-term rates should support economic growth
and employment by lowering the cost of borrowing to buy homes and cars or to finance
capital investments. Since 2008, we've used two types of less-traditional monetary policy
tools to bring down longer-term rates.
The first of these less-traditional tools involves the Fed purchasing longer-term securities on
the open market - principally Treasury securities and mortgage-backed securities
guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac.
The Fed's purchases reduce the amount of longer-term securities held by investors and put
downward pressure on the interest rates on those securities. That downward pressure
transmits to a wide range of interest rates that individuals and businesses pay. For example,
when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year
mortgage interest rates averaged a little above 6percent; today they average about
3-1/2 percent. Lower mortgage rates are one reason for the improvement we have been
seeing in the housing market, which in turn is benefiting the economy more broadly. Other
important interest rates, such as corporate bond rates and rates on auto loans, have also
come down. Lower interest rates also put upward pressure on the prices of assets, such as
stocks and homes, providing further impetus to household and business spending.
The second monetary policy tool we have been using involves communicating our
expectations for how long the short-term interest rate will remain exceptionally low. Because
the yield on, say, a five-year security embeds market expectations for the course of
short-term rates over the next five years, convincing investors that we will keep the
short-term rate low for a longer time can help to pull down market-determined longer-term
rates. In sum, the Fed's basic strategy for strengthening the economy - reducing interest
rates and easing financial conditions more generally - is the same as it has always been.
The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools
aimed at reducing longer-term interest rates more directly.
Last month, my colleagues and I used both tools - securities purchases and communications
about our future actions - in a coordinated way to further support the recovery and the job
market. Why did we act? Though the economy has been growing since mid-2009 and we
expect it to continue to expand, it simply has not been growing fast enough recently to make
significant progress in bringing down unemployment. At 8.1 percent, the unemployment rate
is nearly unchanged since the beginning of the year and is well above normal levels. While
unemployment has been stubbornly high, our economy has enjoyed broad price stability for
some time, and we expect inflation to remain low for the foreseeable future. So the case
seemed clear to most of my colleagues that we could do more to assist economic growth and
the job market without compromising our goal of price stability.
Specifically, what did we do? On securities purchases, we announced that we would buy
mortgage-backed securities guaranteed by the government-sponsored enterprises at a rate
of $40 billion per month. Those purchases, along with the continuation of a previous program
involving Treasury securities, mean we are buying $85 billion of longer-term securities per
month through the end of the year. We expect these purchases to put further downward
pressure on longer-term interest rates, including mortgage rates. To underline the Federal
Reserve's commitment to fostering a sustainable economic recovery, we said that we would
continue securities purchases and employ other policy tools until the outlook for the job
market improves substantially in a context of price stability.
In the category of communications policy, we also extended our estimate of how long we
expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015.
That doesn't mean that we expect the economy to be weak through 2015. Rather, our
message was that, so long as price stability is preserved, we will take care not to raise rates
prematurely. Specifically, we expect that a highly accommodative stance of monetary policy
will remain appropriate for a considerable time after the economy strengthens. We hope that,
by clarifying our expectations about future policy, we can provide individuals, families,
businesses, and financial markets greater confidence about the Federal Reserve's
commitment to promoting a sustainable recovery and that, as a result, they will become more
willing to invest, hire and spend.
Now, as I have said many times, monetary policy is no panacea. It can be used to support
stronger economic growth in situations in which, as today, the economy is not making full use
of its resources, and it can foster a healthier economy in the longer term by maintaining low
and stable inflation. However, many other steps could be taken to strengthen our economy
over time, such as putting the federal budget on a sustainable path, reforming the tax code,
improving our educational system, supporting technological innovation, and expanding
international trade. Although monetary policy cannot cure the economy's ills, particularly in
today's challenging circumstances, we do think it can provide meaningful help. So we at the
Federal Reserve are going to do what we can do and trust that others, in both the public and
private sectors, will do what they can as well.
What's the relationship between monetary policy and fiscal policy?
That brings me to the second question: What's the relationship between monetary policy and
fiscal policy? To answer this question, it may help to begin with the more basic question of
how monetary and fiscal policy differ.
In short, monetary policy and fiscal policy involve quite different sets of actors, decisions, and
tools. Fiscal policy involves decisions about how much the government should spend, how
much it should tax, and how much it should borrow. At the federal level, those decisions are
made by the Administration and the Congress. Fiscal policy determines the size of the
federal budget deficit, which is the difference between federal spending and revenues in a
year. Borrowing to finance budget deficits increases the government's total outstanding debt.
As I have discussed, monetary policy is the responsibility of the Federal Reserve - or, more
specifically, the Federal Open Market Committee, which includes members of the Federal
Reserve's Board of Governors and presidents of Federal Reserve Banks. Unlike fiscal policy,
monetary policy does not involve any taxation, transfer payments, or purchases of goods and
services. Instead, as I mentioned, monetary policy mainly involves the purchase and sale of
securities. The securities that the Fed purchases in the conduct of monetary policy are held
in our portfolio and earn interest. The great bulk of these interest earnings is sent to the
Treasury, thereby helping reduce the government deficit. In the past three years, the Fed
remitted $200 billion to the federal government. Ultimately, the securities held by the Fed will
mature or will be sold back into the market. So the odds are high that the purchase programs
that the Fed has undertaken in support of the recovery will end up reducing, not increasing,
the federal debt, both through the interest earnings we send the Treasury and because a
stronger economy tends to lead to higher tax revenues and reduced government spending
(on unemployment benefits, for example).
Even though our activities are likely to result in a lower national debt over the long term, I
sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by
keeping interest rates very low and thereby making it cheaper for the federal government to
borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely
with the Administration and the Congress. At the Federal Reserve, we implement policy to
promote maximum employment and price stability, as the law under which we operate
requires. Using monetary policy to try to influence the political debate on the budget would be
highly inappropriate. For what it's worth, I think the strategy would also likely be ineffective:
Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest
rates for the purpose of making it more expensive for the government to borrow. Such an
action would substantially increase the deficit, not only because of higher interest rates, but
also because the weaker recovery that would result from premature monetary tightening
would further widen the gap between spending and revenues. Would such a step lead to
better fiscal outcomes? It seems likely that a significant widening of the deficit - which would
make the needed fiscal actions even more difficult and painful - would worsen rather than
improve the prospects for a comprehensive fiscal solution.
I certainly don't underestimate the challenges that fiscal policymakers face. They must find
ways to put the federal budget on a sustainable path, but not so abruptly as to endanger the
economic recovery in the near term. In particular, the Congress and the Administration will
soon have to address the so-called fiscal cliff, a combination of sharply higher taxes and
reduced spending that is set to happen at the beginning of the year. According to the
Congressional Budget Office and virtually all other experts, if that were allowed to occur, it
would likely throw the economy back into recession. The Congress and the Administration
will also have to raise the debt ceiling to prevent the Treasury from defaulting on its
obligations, an outcome that would have extremely negative consequences for the country
for years to come. Achieving these fiscal goals would be even more difficult if monetary
policy were not helping support the economic recovery.
What is the risk that the Federal Reserve's monetary policy will lead to inflation?
A third question, and an important one, is whether the Federal Reserve's monetary policy will
lead to higher inflation down the road. In response, I will start by pointing out that the Federal
Reserve's price stability record is excellent, and we are fully committed to maintaining it.
Inflation has averaged close to 2 percent per year for several decades, and that's about
where it is today. In particular, the low interest rate policies the Fed has been following for
about five years now have not led to increased inflation. Moreover, according to a variety of
measures, the public's expectations of inflation over the long run remain quite stable within
the range that they have been for many years.
With monetary policy being so accommodative now, though, it is not unreasonable to ask
whether we are sowing the seeds of future inflation. A related question I sometimes hear
- which bears also on the relationship between monetary and fiscal policy, is this: By buying
securities, are you "monetizing the debt" - printing money for the government to use - and
will that inevitably lead to higher inflation? No, that's not what is happening, and that will not
happen. Monetizing the debt means using money creation as a permanent source of
financing for government spending. In contrast, we are acquiring Treasury securities on the
open market and only on a temporary basis, with the goal of supporting the economic
recovery through lower interest rates. At the appropriate time, the Federal Reserve will
gradually sell these securities or let them mature, as needed, to return its balance sheet to a
more normal size. Moreover, the way the Fed finances its securities purchases is by creating
reserves in the banking system. Increased bank reserves held at the Fed don't necessarily
translate into more money or cash in circulation, and, indeed, broad measures of the supply
of money have not grown especially quickly, on balance, over the past few years.
For controlling inflation, the key question is whether the Federal Reserve has the policy tools
to tighten monetary conditions at the appropriate time so as to prevent the emergence of
inflationary pressures down the road. I'm confident that we have the necessary tools to
withdraw policy accommodation when needed, and that we can do so in a way that allows us
to shrink our balance sheet in a deliberate and orderly way. For example, the Fed can tighten
policy, even if our balance sheet remains large, by increasing the interest rate we pay banks
on reserve balances they deposit at the Fed. Because banks will not lend at rates lower than
what they can earn at the Fed, such an action should serve to raise rates and tighten credit
conditions more generally, preventing any tendency toward overheating in the economy.
Of course, having effective tools is one thing; using them in a timely way, neither too early
nor too late, is another. Determining precisely the right time to "take away the punch bowl" is
always a challenge for central bankers, but that is true whether they are using traditional or
nontraditional policy tools. I can assure you that my colleagues and I will carefully consider
how best to foster both of our mandated objectives, maximum employment and price
stability, when the time comes to make these decisions.
How does the Fed's monetary policy affect savers and investors?
The concern about possible inflation is a concern about the future. One concern in the here
and now is about the effect of low interest rates on savers and investors. My colleagues and I
know that people who rely on investments that pay a fixed interest rate, such as certificates
of deposit, are receiving very low returns, a situation that has involved significant hardship for
some.
However, I would encourage you to remember that the current low levels of interest rates,
while in the first instance a reflection of the Federal Reserve's monetary policy, are in a
larger sense the result of the recent financial crisis, the worst shock to this nation's financial
system since the 1930s. Interest rates are low throughout the developed world, except in
countries experiencing fiscal crises, as central banks and other policymakers try to cope with
continuing financial strains and weak economic conditions.
A second observation is that savers often wear many economic hats. Many savers are also
homeowners; indeed, a family's home may be its most important financial asset. Many
savers are working, or would like to be. Some savers own businesses, and - through
pension funds and 401(k) accounts - they often own stocks and other assets. The crisis and
recession have led to very low interest rates, it is true, but these events have also destroyed
jobs, hamstrung economic growth, and led to sharp declines in the values of many homes
and businesses. What can be done to address all of these concerns simultaneously? The
best and most comprehensive solution is to find ways to a stronger economy. Only a strong
economy can create higher asset values and sustainably good returns for savers. And only a
strong economy will allow people who need jobs to find them. Without a job, it is difficult to
save for retirement or to buy a home or to pay for an education, irrespective of the current
level of interest rates.
The way for the Fed to support a return to a strong economy is by maintaining monetary
accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to
raise rates now, before the economic recovery is fully entrenched, house prices might
resume declines, the values of businesses large and small would drop, and, critically,
unemployment would likely start to rise again. Such outcomes would ultimately not be good
for savers or anyone else.
How Is the Federal Reserve held accountable in a democratic society?
I will turn, finally, to the question of how the Federal Reserve is held accountable in a
democratic society.
The Federal Reserve was created by the Congress, now almost a century ago. In the
Federal Reserve Act and subsequent legislation, the Congress laid out the central bank's
goals and powers, and the Fed is responsible to the Congress for meeting its mandated
objectives, including fostering maximum employment and price stability. At the same time,
the Congress wisely designed the Federal Reserve to be insulated from short-term political
pressures. For example, members of the Federal Reserve Board are appointed to staggered,
14-year terms, with the result that some members may serve through several
Administrations. Research and practical experience have established that freeing the central
bank from short-term political pressures leads to better monetary policy because it allows
policymakers to focus on what is best for the economy in the longer run, independently of
near-term electoral or partisan concerns. All of the members of the Federal Open Market
Committee take this principle very seriously and strive always to make monetary policy
decisions based solely on factual evidence and careful analysis.
It is important to keep politics out of monetary policy decisions, but it is equally important, in a
democracy, for those decisions - and, indeed, all of the Federal Reserve's decisions and
actions - to be undertaken in a strong framework of accountability and transparency. The
American people have a right to know how the Federal Reserve is carrying out its
responsibilities and how we are using taxpayer resources.
One of my principal objectives as Chairman has been to make monetary policy at the
Federal Reserve as transparent as possible. We promote policy transparency in many ways.
For example, the Federal Open Market Committee explains the reasons for its policy
decisions in a statement released after each regularly scheduled meeting, and three weeks
later we publish minutes with a detailed summary of the meeting discussion. The Committee
also publishes quarterly economic projections with information about where we anticipate
both policy and the economy will be headed over the next several years. I hold news
conferences four times a year and testify often before congressional committees, including
twice-yearly appearances that are specifically designated for the purpose of my presenting a
comprehensive monetary policy report to the Congress. My colleagues and I frequently
deliver speeches, such as this one, in towns and cities across the country.
The Federal Reserve is also very open about its finances and operations. The Federal
Reserve Act requires the Federal Reserve to report annually on its operations and to publish
its balance sheet weekly. Similarly, under the financial reform law enacted after the financial
crisis, we publicly report in detail on our lending programs and securities purchases,
including the identities of borrowers and counterparties, amounts lent or purchased, and
other information, such as collateral accepted. In late 2010, we posted detailed information
on our public website about more than 21,000 individual credit and other transactions
conducted to stabilize markets during the financial crisis. And, just last Friday, we posted the
first in an ongoing series of quarterly reports providing a great deal of information on
individual discount window loans and securities transactions. The Federal Reserve's financial
statement is audited by an independent, outside accounting firm, and an independent
Inspector General has wide powers to review actions taken by the Board. Importantly, the
Government Accountability Office (GAO) has the ability to - and does - oversee the
efficiency and integrity of all of our operations, including our financial controls and
governance.
While the GAO has access to all aspects of the Fed's operations and is free to criticize or
make recommendations, there is one important exception: monetary policymaking. In the
1970s, the Congress deliberately excluded monetary policy deliberations, decisions, and
actions from the scope of GAO reviews. In doing so, the Congress carefully balanced the
need for democratic accountability with the benefits that flow from keeping monetary policy
free from short-term political pressures.
However, there have been recent proposals to expand the authority of the GAO over the
Federal Reserve to include reviews of monetary policy decisions. Because the GAO is the
investigative arm of the Congress and GAO reviews may be initiated at the request of
members of the Congress, these reviews (or the prospect of reviews) of individual policy
decisions could be seen, with good reason, as efforts to bring political pressure to bear on
monetary policymakers. A perceived politicization of monetary policy would reduce public
confidence in the ability of the Federal Reserve to make its policy decisions based strictly on
what is good for the economy in the longer term. Balancing the need for accountability
against the goal of insulating monetary policy from short-term political pressure is very
important, and I believe that the Congress had it right in the 1970s when it explicitly chose to
protect monetary policy decisionmaking from the possibility of politically motivated reviews.
Conclusion
In conclusion, I will simply note that these past few years have been a difficult time for the
nation and the economy. For its part, the Federal Reserve has also been tested by
unprecedented challenges. As we approach next year's 100th anniversary of the signing of
the Federal Reserve Act, however, I have great confidence in the institution. In particular, I
would like to recognize the skill, professionalism, and dedication of the employees of the
Federal Reserve System. They work tirelessly to serve the public interest and to promote
prosperity for people and businesses across America. The Fed's policy choices can always
be debated, but the quality and commitment of the Federal Reserve as a public institution is
second to none, and I am proud to lead it.
Now that I've answered questions that I've posed to myself, I'd be happy to respond to yours.