Bernanke, Bullard, And QE3

by: Tim Duy

Monday, Federal Reserve Chairman Ben Bernanke gave a speech that apparently was identified as proof that QE3 is still in the cards. He argues that while labor markets have shown improvement in recent months, conditions are far from normal. Moreover, he sees the problem of long-term unemployment as largely structural, and delivers what many believed to be the money quote:

I will argue today that, while both cyclical and structural forces have doubtless contributed to the increase in long-term unemployment, the continued weakness in aggregate demand is likely the predominant factor. Consequently, the Federal Reserve's accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well.

In my opinion, to interpret this as a call for additional quantitative easing is a bit of a stretch. It sounds like simply a confirmation that Bernanke believes the current policy stance is appropriate and that the existence of long-term unemployment should not be viewed as a reason to believe that we are closing in on a resource constraint that would necessitate a tightening of the policy stance. I was drawn to a much more nuanced section:

However, to the extent that the decline in the unemployment rate since last summer has brought unemployment back more into line with the level of aggregate demand, then further significant improvements in unemployment will likely require faster economic growth than we experienced during the past year. It will be especially important to evaluate incoming information to assess whether the recovery is picking up as improvements in the labor market feed through to consumer and business confidence; or, conversely, whether the headwinds that have impeded the recovery to date continue to restrain the pace at which the labor market and economic activity normalize.

In essence, Bernanke suggests that the recent rapid improvements in unemployment reflect largely a reversal of out-sized deterioration experienced during the recession. As such, we should not expect a slower pace of improvement given current growth forecasts. Under such conditions, I believe, Bernanke would push for another round of QE - although it stills begs the question of why he doesn't push for more now given the existing forecasts. But he hasn't, so we can only infer that he thinks the costs of additional easing outweigh the benefits.

He leaves open the possibility, however, that labor markets will continue to improve at the recent pace, in which I think QE3 is off the table. And that is where Federal Reserve President James Bullard steps in to the picture. He said pretty much the same thing in a CNBC interview:

"I think QE3 would require the economy to deteriorate somewhat from where it is right now," Bullard said. "The basic story on the U.S. economy is that we've had good news over the last six months or so, especially compared to the recession scenario that was being painted in the August-September time period of last year."

That said, this is somewhat softer language than he used in a speech last week:

But now, with the Committee on pause, it may be a good time to take stock of whether we may be at a turning point. Many of the further policy actions the Committee might consider at this juncture would have effects extending out for several years. As the U.S. economy continues to rebound and repair, those policy actions may create an overcommitment to ultra-easy monetary policy. The ultra-easy policy has been appropriate until now, but it will not always be appropriate.

The FOMC has often been criticized historically for overstaying policy stances that might have made sense at one juncture but are no longer appropriate as macroeconomic conditions change. This occurs in part because of the lags in the effects of policy, the difficulty in interpreting real-time data, much of which is subsequently revised, and the sheer uncertainty of macroeconomic developments. With numerous monetary policy actions still on the table, and others still affecting the economy with a lag, it may be especially difficult to remove policy accommodation at the appropriate pace and at the appropriate time. One may want to approach such a situation with caution.

This seems to suggest he is in fact entertaining the possibility that the turning point for policy will occur sooner than expected. My view is that the crux of any disagreement between Bullard and Bernanke is the timing of any tightening. Both would push for additional easing should conditions deteriorate. But Bernanke is willing to leave existing policy in place for well into the future, whereas Bullard is looking forward to pulling the trigger on tighter policy sooner than later.

This, by the way, is a debate Bernanke would win in the absence of clear indications that tightening is necessary.

Incredibly, in his CNBC interview, Bullard strays into the world of Japanese monetary policy:

"I think one of the biggest mistakes is continue to throw us much more in the way of monetary injections into the economy and with that, you get a much higher increase in commodity prices and potentially produce less global consumption across the world, which slows economic activity down," Bullard said. "I'm afraid that's the real danger just now - that we've maintained too loose of a policy right across the global economy and what results is inflation and reduction in real spending power."

I get this, I really do. But I have come to the conclusion that the Federal Reserve should not consider the reaction functions of other central banks when setting policy. Simply put, this is not the Fed's problem. To the extent that other nations import the Fed's monetary policy, they do so by choice. Bullard continues:

Bullard says he would like to see the Federal Reserve resume a "more normal monetary policy as soon as possible" because it has detrimental effects on the economy.

"It (the policy) punishes savers, for instance, in the economy, it does send a pessimistic signal about the economy and I think that can hurt investment prospects in the U.S.," Bullard said. "But we need to provide the right amount of support for the recovery as we do that, and we need to keep an eye on inflation."

Concerns that like the commodity price issue seem to mimic those of Bank of Japan Governor Masaaki Shirakawa. And we all know what about the wisdom of BoJ monetary policy.

Bottom Line: I do not think Bernanke's speech is a signal that QE3 is guaranteed. But it is a signal that QE3 is definitely not off the table. It is entirely data dependent. The current flow of data does not support additional action. I don't think it would take much of a deterioration to prompt additional action, so if you have a bearish view of the US economy, expect QE3. But if you have a bullish view, don't expect a rapid policy reversal. Bernanke isn't ready to go there.