Ben S Bernanke: The economic outlook and monetary policy
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole,
Wyoming, 27 August 2010.
* * *
The annual meeting at Jackson Hole always provides a valuable opportunity to reflect on the
economic and financial developments of the preceding year, and recently we have had a
great deal on which to reflect. A year ago, in my remarks to this conference, I reviewed the
response of the global policy community to the financial crisis.1 On the whole, when the
eruption of the Panic of 2008 threatened the very foundations of the global economy, the
world rose to the challenge, with a remarkable degree of international cooperation, despite
very difficult conditions and compressed time frames. And when last we gathered here, there
were strong indications that the sharp contraction of the global economy of late 2008 and
early 2009 had ended. Most economies were growing again, and international trade was
once again expanding.
Notwithstanding some important steps forward, however, as we return once again to Jackson
Hole I think we would all agree that, for much of the world, the task of economic recovery and
repair remains far from complete. In many countries, including the United States and most
other advanced industrial nations, growth during the past year has been too slow and
joblessness remains too high. Financial conditions are generally much improved, but bank
credit remains tight; moreover, much of the work of implementing financial reform lies ahead
of us. Managing fiscal deficits and debt is a daunting challenge for many countries, and
imbalances in global trade and current accounts remain a persistent problem.
This list of concerns makes clear that a return to strong and stable economic growth will
require appropriate and effective responses from economic policymakers across a wide
spectrum, as well as from leaders in the private sector. Central bankers alone cannot solve
the world's economic problems. That said, monetary policy continues to play a prominent
role in promoting the economic recovery and will be the focus of my remarks today. I will
begin with an update on the economic outlook in the United States and then review the
measures that the Federal Open Market Committee (FOMC) has taken to support the
economic recovery and maintain price stability. I will conclude by discussing and evaluating
some policy options that the FOMC has at its disposal, should further action become
necessary.
The economic outlook
As I noted at the outset, when we last gathered here, the deep economic contraction had
ended, and we were seeing broad stabilization in global economic activity and the beginnings
of a recovery. Concerted government efforts to restore confidence in the financial system,
including the aggressive provision of liquidity by central banks, were essential in achieving
that outcome. Monetary policies in many countries had been eased aggressively. Fiscal
policy - including stimulus packages, expansions of the social safety net, and the
countercyclical spending and tax policies known collectively as automatic stabilizers - also
helped to arrest the global decline. Once demand began to stabilize, firms gained sufficient
confidence to increase production and slow the rapid liquidation of inventories that they had
begun during the contraction. Expansionary fiscal policies and a powerful inventory cycle,
helped by a recovery in international trade and improved financial conditions, fueled a
significant pickup in growth.
At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily.
For a sustained expansion to take hold, growth in private final demand - notably, consumer
spending and business fixed investment - must ultimately take the lead. On the whole, in the
United States, that critical handoff appears to be under way.
However, although private final demand, output, and employment have indeed been growing
for more than a year, the pace of that growth recently appears somewhat less vigorous than
we expected. Notably, since stabilizing in mid-2009, real household spending in the United
States has grown in the range of 1 to 2 percent at annual rates, a relatively modest pace.
Households' caution is understandable. Importantly, the painfully slow recovery in the labor
market has restrained growth in labor income, raised uncertainty about job security and
prospects, and damped confidence. Also, although consumer credit shows some signs of
thawing, responses to our Senior Loan Officer Opinion Survey on Bank Lending Practices
suggest that lending standards to households generally remain tight.2
The prospects for household spending depend to a significant extent on how the jobs
situation evolves. But the pace of spending will also depend on the progress that households
make in repairing their financial positions. Among the most notable results to emerge from
the recent revision of the U.S. national income data is that, in recent quarters, household
saving has been higher than we thought - averaging near 6 percent of disposable income
rather than 4 percent, as the earlier data showed.3 On the one hand, this finding suggests
that households, collectively, are even more cautious about the economic outlook and their
own prospects than we previously believed. But on the other hand, the upward revision to the
saving rate also implies greater progress in the repair of household balance sheets. Stronger
balance sheets should in turn allow households to increase their spending more rapidly as
credit conditions ease and the overall economy improves.
Household finances and attitudes also bear heavily on the housing market, which has
generally remained depressed. In particular, home sales dropped sharply following the
recent expiration of the homebuyers' tax credit. Going forward, improved affordability - the
result of lower house prices and record-low mortgage rates - should boost the demand for
housing. However, the overhang of foreclosed-upon and vacant housing and the difficulties
of many households in obtaining mortgage financing are likely to continue to weigh on the
pace of residential investment for some time yet.
In the business sector, real investment in equipment and software rose at an annual rate of
more than 20 percent over the first half of the year. Some of these gains no doubt reflected
spending that had been deferred during the crisis, including investments to replace or update
existing equipment. Consequently, investment in equipment and software will almost
certainly increase more slowly over the remainder of this year, though it should continue to
advance at a solid pace. In contrast, outside of a few areas such as drilling and mining,
business investment in structures has continued to contract, although the rate of contraction
appears to be slowing.
Although most firms faced problems obtaining credit during the depths of the crisis, over the
past year or so a divide has opened between large firms that are able to tap public securities
markets and small firms that largely depend on banks. Generally speaking, large firms in
good financial condition can obtain credit easily and on favorable terms; moreover, many
large firms are holding exceptionally large amounts of cash on their balance sheets. For
these firms, willingness to expand - and, in particular, to add permanent employees -
depends primarily on expected increases in demand for their products, not on financing
costs. Bank-dependent smaller firms, by contrast, have faced significantly greater problems
obtaining credit, according to surveys and anecdotes. The Federal Reserve, together with
other regulators, has been engaged in significant efforts to improve the credit environment
for small businesses. For example, through the provision of specific guidance and extensive
examiner training, we are working to help banks strike a good balance between appropriate
prudence and reasonable willingness to make loans to creditworthy borrowers. We have also
engaged in extensive outreach efforts to banks and small businesses. There is some hopeful
news on this front: For the most part, bank lending terms and conditions appear to be
stabilizing and are even beginning to ease in some cases, and banks reportedly have
become more proactive in seeking out creditworthy borrowers.
Incoming data on the labor market have remained disappointing. Private-sector employment
has grown only sluggishly, the small decline in the unemployment rate is attributable more to
reduced labor force participation than to job creation, and initial claims for unemployment
insurance remain high. Firms are reluctant to add permanent employees, citing slow growth
of sales and elevated economic and regulatory uncertainty. In lieu of adding permanent
workers, some firms have increased labor input by increasing workweeks, offering full-time
work to part-time workers, and making extensive use of temporary workers.
Besides consumption spending and business fixed investment, net exports are a third source
of demand for domestic production. The substantial recovery in international trade is a very
positive development for the global economy; for the United States, improving export
markets are an important reason that manufacturing has been a leading sector in the
recovery. Like others, we were surprised by the sharp deterioration in the U.S. trade balance
in the second quarter. However, that deterioration seems to have reflected a number of
temporary and special factors. Generally, the arithmetic contribution of net exports to growth
in the gross domestic product tends to be much closer to zero, and that is likely to be the
case in coming quarters.
Overall, the incoming data suggest that the recovery of output and employment in the United
States has slowed in recent months, to a pace somewhat weaker than most FOMC
participants projected earlier this year. Much of the unexpected slowing is attributable to the
household sector, where consumer spending and the demand for housing have both grown
less quickly than was anticipated. Consumer spending may continue to grow relatively slowly
in the near term as households focus on repairing their balance sheets. I expect the
economy to continue to expand in the second half of this year, albeit at a relatively modest
pace.
Despite the weaker data seen recently, the preconditions for a pickup in growth in 2011
appear to remain in place. Monetary policy remains very accommodative, and financial
conditions have become more supportive of growth, in part because a concerted effort by
policymakers in Europe has reduced fears related to sovereign debts and the banking
system there. Banks are improving their balance sheets and appear more willing to lend.
Consumers are reducing their debt and building savings, returning household
wealth-toincome ratios near to longer-term historical norms. Stronger household finances, rising
incomes, and some easing of credit conditions will provide the basis for more-rapid growth in
household spending next year.
Businesses' investment in equipment and software should continue to grow at a healthy pace
in the coming year, driven by rising demand for products and services, the continuing need to
replace or update existing equipment, strong corporate balance sheets, and the low cost of
financing, at least for those firms with access to public capital markets. Rising sales and
increased business confidence should also lead firms to expand payrolls. However,
investment in structures will likely remain weak. On the fiscal front, state and local
governments continue to be under pressure; but with tax receipts showing signs of recovery,
their spending should decline less rapidly than it has in the past few years. Federal fiscal
stimulus seems set to continue to fade but likely not so quickly as to derail growth in coming
quarters.
Although output growth should be stronger next year, resource slack and unemployment
seem likely to decline only slowly. The prospect of high unemployment for a long period of
time remains a central concern of policy. Not only does high unemployment, particularly
longterm unemployment, impose heavy costs on the unemployed and their families and on
society, but it also poses risks to the sustainability of the recovery itself through its effects on
households' incomes and confidence.
Maintaining price stability is also a central concern of policy. Recently, inflation has declined
to a level that is slightly below that which FOMC participants view as most conducive to a
healthy economy in the long run. With inflation expectations reasonably stable and the
economy growing, inflation should remain near current readings for some time before rising
slowly toward levels more consistent with the Committee's objectives. At this juncture, the
risk of either an undesirable rise in inflation or of significant further disinflation seems low. Of
course, the Federal Reserve will monitor price developments closely.
In the remainder of my remarks I will discuss the policies the Federal Reserve is currently
using to support economic recovery and price stability. I will also discuss some additional
policy options that we could consider, especially if the economic outlook were to deteriorate
further.
Federal Reserve policy
In 2008 and 2009, the Federal Reserve, along with policymakers around the world, took
extraordinary actions to arrest the financial crisis and help restore normal functioning in key
financial markets, a precondition for economic stabilization. To provide further support for the
economic recovery while maintaining price stability, the Fed has also taken extraordinary
measures to ease monetary and financial conditions.
Notably, since December 2008, the FOMC has held its target for the federal funds rate in a
range of 0 to 25 basis points. Moreover, since March 2009, the Committee has consistently
stated its expectation that economic conditions are likely to warrant exceptionally low policy
rates for an extended period. Partially in response to FOMC communications, futures
markets quotes suggest that investors are not anticipating significant policy tightening by the
Federal Reserve for quite some time. Market expectations for continued accommodative
policy have in turn helped reduce interest rates on a range of short- and medium-term
financial instruments to quite low levels, indeed not far above the zero lower bound on
nominal interest rates in many cases.
The FOMC has also acted to improve market functioning and to push longer-term interest
rates lower through its large-scale purchases of agency debt, agency mortgage-backed
securities (MBS), and longer-term Treasury securities, of which the Federal Reserve
currently holds more than $2 trillion. The channels through which the Fed's purchases affect
longer-term interest rates and financial conditions more generally have been subject to
debate. I see the evidence as most favorable to the view that such purchases work primarily
through the so-called portfolio balance channel, which holds that once short-term interest
rates have reached zero, the Federal Reserve's purchases of longer-term securities affect
financial conditions by changing the quantity and mix of financial assets held by the public.
Specifically, the Fed's strategy relies on the presumption that different financial assets are
not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset
available to investors affect its yield and those of broadly similar assets. Thus, our purchases
of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities
and also pushed investors into holding other assets with similar characteristics, such as
credit risk and duration. For example, some investors who sold MBS to the Fed may have
replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing
the yields on those assets as well.
The logic of the portfolio balance channel implies that the degree of accommodation
delivered by the Federal Reserve's securities purchase program is determined primarily by
the quantity and mix of securities the central bank holds or is anticipated to hold at a point in
time (the "stock view"), rather than by the current pace of new purchases (the "flow view"). In
support of the stock view, the cessation of the Federal Reserve's purchases of agency
securities at the end of the first quarter of this year seems to have had only negligible effects
on longer-term rates and spreads.
The Federal Reserve did not hold the size of its securities portfolio precisely constant after it
ended its agency purchase program earlier this year. Instead, consistent with the
Committee's goal of ultimately returning the portfolio to one consisting primarily of Treasury
securities, we adopted a policy of re-investing maturing Treasuries in similar securities while
allowing agency securities to run off as payments of principal were received. To date, we
have realized about $140 billion of repayments of principal on our holdings of agency debt
and MBS, most of it prior to the end of the purchase program. Continued repayments at this
pace, together with the policy of not re-investing the proceeds, were expected to lead to a
slight reduction in policy accommodation over time.
However, more recently, as the pace of economic growth has slowed somewhat, longer-term
interest rates have fallen and mortgage refinancing activity has picked up. Increased
refinancing has in turn led the Fed's holding of agency MBS to run off more quickly than
previously anticipated. Although mortgage prepayment rates are difficult to predict, under the
assumption that mortgage rates remain near current levels, we estimated that an additional
$400 billion or so of MBS and agency debt currently in the Fed's portfolio could be repaid by
the end of 2011.
At their most recent meeting, FOMC participants observed that allowing the Federal
Reserve's balance sheet to shrink in this way at a time when the outlook had weakened
somewhat was inconsistent with the Committee's intention to provide the monetary
accommodation necessary to support the recovery. Moreover, a bad dynamic could come
into at play: Any further weakening of the economy that resulted in lower longer-term interest
rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even
more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy
might act indirectly to increase the pace of passive policy tightening - a perverse outcome. In
response to these concerns, the FOMC agreed to stabilize the quantity of securities held by
the Federal Reserve by re-investing payments of principal on agency securities into
longerterm Treasury securities. We decided to reinvest in Treasury securities rather than agency
securities because the Federal Reserve already owns a very large share of available agency
securities, suggesting that reinvestment in Treasury securities might be more effective in
reducing longer-term interest rates and improving financial conditions with less chance of
adverse effects on market functioning. Also, as I already noted, reinvestment in Treasury
securities is more consistent with the Committee's longer-term objective of a portfolio made
up principally of Treasury securities. We do not rule out changing the reinvestment strategy if
circumstances warrant, however.
By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the
Committee avoided an undesirable passive tightening of policy that might otherwise have
occurred. The decision also underscored the Committee's intent to maintain accommodative
financial conditions as needed to support the recovery. We will continue to monitor economic
developments closely and to evaluate whether additional monetary easing would be
beneficial. In particular, the Committee is prepared to provide additional monetary
accommodation through unconventional measures if it proves necessary, especially if the
outlook were to deteriorate significantly. The issue at this stage is not whether we have the
tools to help support economic activity and guard against disinflation. We do. As I will discuss
next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of
additional stimulus, outweigh the associated costs or risks of using the tool.
Policy options for further easing
Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal
Reserve retains a number of tools and strategies for providing additional stimulus. I will focus
here on three that have been part of recent staff analyses and discussion at FOMC
meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the
Committee's communication, and (3) reducing the interest paid on excess reserves. I will
also comment on a fourth strategy, proposed by several economists - namely, that the
FOMC increase its inflation goals.
A first option for providing additional monetary accommodation, if necessary, is to expand the
Federal Reserve's holdings of longer-term securities. As I noted earlier, the evidence
suggests that the Fed's earlier program of purchases was effective in bringing down term
premiums and lowering the costs of borrowing in a number of private credit markets. I regard
the program (which was significantly expanded in March 2009) as having made an important
contribution to the economic stabilization and recovery that began in the spring of 2009.
Likewise, the FOMC's recent decision to stabilize the Federal Reserve's securities holdings
should promote financial conditions supportive of recovery.
I believe that additional purchases of longer-term securities, should the FOMC choose to
undertake them, would be effective in further easing financial conditions. However, the
expected benefits of additional stimulus from further expanding the Fed's balance sheet
would have to be weighed against potential risks and costs. One risk of further balance sheet
expansion arises from the fact that, lacking much experience with this option, we do not have
very precise knowledge of the quantitative effect of changes in our holdings on financial
conditions. In particular, the impact of securities purchases may depend to some extent on
the state of financial markets and the economy; for example, such purchases seem likely to
have their largest effects during periods of economic and financial stress, when markets are
less liquid and term premiums are unusually high. The possibility that securities purchases
would be most effective at times when they are most needed can be viewed as a positive
feature of this tool. However, uncertainty about the quantitative effect of securities purchases
increases the difficulty of calibrating and communicating policy responses.
Another concern associated with additional securities purchases is that substantial further
expansions of the balance sheet could reduce public confidence in the Fed's ability to
execute a smooth exit from its accommodative policies at the appropriate time. Even if
unjustified, such a reduction in confidence might lead to an undesired increase in inflation
expectations. (Of course, if inflation expectations were too low, or even negative, an increase
in inflation expectations could become a benefit.) To mitigate this concern, the Federal
Reserve has expended considerable effort in developing a suite of tools to ensure that the
exit from highly accommodative policies can be smoothly accomplished when appropriate,
and FOMC participants have spoken publicly about these tools on numerous occasions.
Indeed, by providing maximum clarity to the public about the methods by which the FOMC
will exit its highly accommodative policy stance - and thereby helping to anchor inflation
expectations - the Committee increases its own flexibility to use securities purchases to
provide additional accommodation, should conditions warrant.
A second policy option for the FOMC would be to ease financial conditions through its
communication, for example, by modifying its post-meeting statement. As I noted, the
statement currently reflects the FOMC's anticipation that exceptionally low rates will be
warranted "for an extended period," contingent on economic conditions. A step the
Committee could consider, if conditions called for it, would be to modify the language in the
statement to communicate to investors that it anticipates keeping the target for the federal
funds rate low for a longer period than is currently priced in markets. Such a change would
presumably lower longer-term rates by an amount related to the revision in policy
expectations.
Central banks around the world have used a variety of methods to provide future guidance
on rates. For example, in April 2009, the Bank of Canada committed to maintain a low policy
rate until a specific time, namely, the end of the second quarter of 2010, conditional on the
inflation outlook.4 Although this approach seemed to work well in Canada, committing to
keep the policy rate fixed for a specific period carries the risk that market participants may
not fully appreciate that any such commitment must ultimately be conditional on how the
economy evolves (as the Bank of Canada was careful to state). An alternative
communication strategy is for the central bank to explicitly tie its future actions to specific
developments in the economy. For example, in March 2001, the Bank of Japan committed to
maintaining its policy rate at zero until Japanese consumer prices stabilized or exhibited a
year-on-year increase. A potential drawback of using the FOMC's post-meeting statement to
influence market expectations is that, at least without a more comprehensive framework in
place, it may be difficult to convey the Committee's policy intentions with sufficient precision
and conditionality. The Committee will continue to actively review its communication strategy,
with the goal of communicating its outlook and policy intentions as clearly as possible.
A third option for further monetary policy easing is to lower the rate of interest that the Fed
pays banks on the reserves they hold with the Federal Reserve System. Inside the Fed this
rate is known as the IOER rate, the "interest on excess reserves" rate. The IOER rate,
currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. On
the margin, a reduction in the IOER rate would provide banks with an incentive to increase
their lending to non-financial borrowers or to participants in short-term money markets,
reducing short-term interest rates further and possibly leading to some expansion in money
and credit aggregates. However, under current circumstances, the effect of reducing the
IOER rate on financial conditions in isolation would likely be relatively small. The federal
funds rate is currently averaging between 15 and 20 basis points and would almost certainly
remain positive after the reduction in the IOER rate. Cutting the IOER rate even to zero
would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis
points. The effect on longer-term rates would probably be even less, although that effect
would depend in part on the signal that market participants took from the action about the
likely future course of policy. Moreover, such an action could disrupt some key financial
markets and institutions. Importantly for the Fed's purposes, a further reduction in very
shortterm interest rates could lead short-term money markets such as the federal funds market to
become much less liquid, as near-zero returns might induce many participants and
marketmakers to exit. In normal times the Fed relies heavily on a well-functioning federal funds
market to implement monetary policy, so we would want to be careful not to do permanent
damage to that market.
A rather different type of policy option, which has been proposed by a number of economists,
would have the Committee increase its medium-term inflation goals above levels consistent
with price stability. I see no support for this option on the FOMC. Conceivably, such a step
might make sense in a situation in which a prolonged period of deflation had greatly
weakened the confidence of the public in the ability of the central bank to achieve price
stability, so that drastic measures were required to shift expectations. Also, in such a
situation, higher inflation for a time, by compensating for the prior period of deflation, could
help return the price level to what was expected by people who signed long-term contracts,
such as debt contracts, before the deflation began.
However, such a strategy is inappropriate for the United States in current circumstances.
Inflation expectations appear reasonably well-anchored, and both inflation expectations and
actual inflation remain within a range consistent with price stability. In this context, raising the
inflation objective would likely entail much greater costs than benefits. Inflation would be
higher and probably more volatile under such a policy, undermining confidence and the
ability of firms and households to make longer-term plans, while squandering the Fed's
hardwon inflation credibility. Inflation expectations would also likely become significantly less
stable, and risk premiums in asset markets - including inflation risk premiums - would rise.
The combination of increased uncertainty for households and businesses, higher risk
premiums in financial markets, and the potential for destabilizing movements in commodity
and currency markets would likely overwhelm any benefits arising from this strategy.
Each of the tools that the FOMC has available to provide further policy accommodation
- including longer-term securities asset purchases, changes in communication, and reducing
the IOER rate - has benefits and drawbacks, which must be appropriately balanced. Under
what conditions would the FOMC make further use of these or related policy tools? At this
juncture, the Committee has not agreed on specific criteria or triggers for further action, but I
can make two general observations.
First, the FOMC will strongly resist deviations from price stability in the downward direction.
Falling into deflation is not a significant risk for the United States at this time, but that is true
in part because the public understands that the Federal Reserve will be vigilant and proactive
in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were
to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly
more favorable.
Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure
continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is
committed to promoting growth in employment and reducing resource slack more generally.
Because a further significant weakening in the economic outlook would likely be associated
with further disinflation, in the current environment there is little or no potential conflict
between the goals of supporting growth and employment and of maintaining price stability.
Conclusion
This morning I have reviewed the outlook, the Federal Reserve's response, and its policy
options for the future should the recovery falter or inflation decline further.
In sum, the pace of recovery in output and employment has slowed somewhat in recent
months, in part because of slower-than-expected growth in consumer spending, as well as
continued weakness in residential and non-residential construction. Despite this recent
slowing, however, it is reasonable to expect some pickup in growth in 2011 and in
subsequent years. Broad financial conditions, including monetary policy, are supportive of
growth, and banks appear to have become somewhat more willing to lend. Importantly,
households may have made more progress than we had earlier thought in repairing their
balance sheets, allowing them more flexibility to increase their spending as conditions
improve. And as the expansion strengthens, firms should become more willing to hire.
Inflation should remain subdued for some time, with low risks of either a significant increase
or decrease from current levels.
Although what I have just described is, I believe, the most plausible outcome,
macroeconomic projections are inherently uncertain, and the economy remains vulnerable to
unexpected developments. The Federal Reserve is already supporting the economic
recovery by mainta