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For the second time since he became chairman in 2006, Ben S. Bernanke is leading the Federal Reserve into uncharted monetary territory.
Bernanke next week is likely to preside over a decision to launch another round of large-scale asset purchases after deploying $1.7 trillion to pull the economy out of the financial crisis, comments from policy makers over the past week indicate. This time, with interest rates already near zero, the Fed will be aiming to increase the rate of inflation and reduce the cost of borrowing in real terms. The goal is to unlock consumer spending and jump-start an economy that’s growing too slowly to push unemployment lower.
Estimates for the ultimate size of the asset-purchase program range from $1 trillion at Bank of America-Merrill Lynch Global Research to $2 trillion at Goldman Sachs Group Inc., with economists at both firms agreeing the Fed will likely start by announcing $500 billion after the Nov. 2-3 meeting. The danger is that once the Fed kindles price increases, inflation will be difficult to control.
“By reducing real interest rates and trying to break the psychology of ‘Why spend today when I can buy goods cheaper tomorrow,’ they are hoping to drive growth that would be more commensurate with a pickup in employment,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. “The risk is a late 1970s type of scenario where the inflation genie gets out of the bottle.”
The U.S. Treasury Department yesterday sold $10 billion of five-year Treasury Inflation Protected Securities at a negative yield for the first time at a U.S. debt auction as investors bet the Fed will be successful in sparking inflation. The securities drew a yield of negative 0.55 percent.
William Dudley, president of the New York Fed and vice chairman of the Federal Open Market Committee, yesterday repeated that current levels of inflation and a 9.6 percent unemployment rate are “unacceptable” and said the Fed needs to take action, even though expanding the balance sheet isn’t a “perfect tool.”
“To the extent that we can do things to improve the economic environment, we certainly owe it to the millions of people who are unemployed to do so,” Dudley said in response to audience questions after a speech in Ithaca, New York. Policy makers haven’t yet decided whether to buy additional assets, he said.
A second jolt of monetary stimulus would expand the Fed’s $2.3 trillion balance sheet to a record and likely work through the exchange rate as well as interest rates, said former Fed governor Lyle Gramley. A weaker dollar would boost U.S. exports and push prices higher as the cost of imported goods rises.
“It is a channel that works not only from the standpoint of encouraging more growth and making exports more competitive, but if you’re worried about inflation getting too low, this tends to put a little upward pressure” on it, said Gramley, a senior adviser at Potomac Research Group in Washington.
An index of the dollar versus six major currencies is down 5.2 percent since Sept. 20, the day before Fed officials concluded their last meeting by saying inflation measures were “somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” The Standard and Poor’s 500 Index is up 3.8 percent since then.
A 10 percent decline in the dollar in the first six months of next year would push the economy above estimates of trend growth, moving indicators on inflation and employment more rapidly toward the Fed’s policy goals, according to a simulation run by Macroeconomic Advisers LLC on their model of the U.S. economy.
Effect on GDP
Gross domestic product would rise 1.1 percentage points more than the St. Louis-based firm’s baseline forecast for next year, to 4.8 percent. In 2012, growth of 5.7 percent would exceed the baseline forecast by 1.3 percentage points.
Unemployment would fall to 7 percent by the end of 2012, 1.4 points lower than the firm’s baseline forecast. The consumer price index, minus food and energy, would rise 0.4 percent and 0.7 percent more each year.
A continuing rally in stocks could also provide an added lift to growth, the firm’s simulation showed.
The firm, co-founded by former Fed governor Laurence Meyer, predicts the Wilshire 5000 stock index will jump 14 percent next year and 16 percent in 2012. The index tracks the impact of rising asset prices on household net worth. An additional 10 percent gain in the stock index in the first half of 2011 boosts growth by 0.1 percentage point and 0.3 percentage point more than the firm’s baseline forecast.
“The transmission mechanisms are risk assets and a lower dollar,” said Steven Einhorn, who helps manage $5 billion at hedge fund Omega Advisors Inc. in New York. “Exports will respond over the next six to 12 months, and a further lift in risk assets will have benefits in more consumer spending as it lifts households’ net worth.”
A weaker dollar won’t be welcomed by U.S. trading partners concerned about the danger of competitive devaluations as nations seek to boost exports and growth.
Bernanke received “criticism” at a meeting of Group of 20 central bankers and finance ministers in South Korea last weekend, said German Economy Minister Rainer Bruederle.
“It’s the wrong way to try to prevent or solve problems by adding more liquidity,” Bruederle told reporters. “Excessive, permanent money creation in my opinion is an indirect manipulation of an exchange rate.”
Economists Jan Hatzius at Goldman Sachs and Ethan Harris at Bank of America predict the Fed will spread an initial $500 billion in asset purchases over six months. That is the figure mentioned in the Oct. 1 speech by Dudley, who said $500 billion in purchases could have the same effect as cutting the benchmark federal funds rate by as much as a 0.75 percentage point.
The FOMC’s meeting next week could be contentious, with regional bank presidents such as Charles Plosser of Philadelphia and Richard Fisher of Dallas expressing concern in public remarks about a second round of asset purchases. Neither is a voting member of the FOMC this year.
Plosser told reporters Oct. 20 that high unemployment may not be “amenable to monetary-policy solutions” and added that he was “less inclined to want to follow a policy that is highly concentrated on raising inflation and raising inflation expectations.”
Fisher said central bank officials must be mindful of the effect their actions are having on the dollar.
“We need to be aware of the impact whatever we do has on other variables, and one of the variables is the dollar, the value of the dollar against other currencies,” Fisher said in an Oct. 22 interview in New York.
The prospect of an easier policy for a long period could prompt foreign investors to use Fed purchases as an opportunity to unload longer-term Treasuries, said Vincent Reinhart, former director of the Fed Board’s Division of Monetary Affairs.
“This might put more pressure on the exchange value of the dollar than the Fed is willing to tolerate,” said Reinhart, a resident scholar at the American Enterprise Institute in Washington.
Some commodity prices have already started to move up in anticipation of further Fed stimulus. Gold futures traded on the Comex in New York have risen 22 percent this year to $1,338.90 an ounce, while silver is up 40 percent.
“The Fed would like to talk up as many asset classes as it can,” said Scott Minerd, the Santa Monica-based chief investment officer at Guggenheim Partners LLC, who helps oversee $76 billion.
“The history of the Fed, over the last 20 years, is one of bubble to bubble: one bubble deflates to create another bubble,” Minerd said. “We are certainly heading into the mother of all bubbles with commodities and gold.”
Another danger for the Fed is that its policy fails to have the intended effect, damaging the central bank’s credibility, Reinhart said.
“What happens if they bulk up the portfolio by another $500 billion in the next six months and there is no material change in markets or the outlook,” he said. “Presumably, the Fed will double-down and buy some more, but at some point, people will ask, ‘Is that all there is?’”
U.S. central bankers cut the benchmark lending rate to zero in December 2008. Seeking more stimulus, they launched a $1.7 trillion program to buy mortgage-backed securities, housing agency debt and U.S. Treasuries. The purchases ended in March.
Bernanke told central bankers in Jackson Hole, Wyoming, in August that those purchases “pushed investors into holding other assets with similar characteristics,” lowering interest rates on a broad range of debt.
While a second round of Treasury purchases would also lower nominal rates, the FOMC has been explicit about the need to lower real interest rates through higher inflation, minutes of its Sept. 21 meeting show.
The personal consumption expenditures price index, minus food and energy, rose at a 1.4 percent annual rate in August. That’s below the Fed’s long-run preference range of 1.7 percent to 2 percent. The year-over-year increase in consumer prices jumped as high as 14.8 percent in 1980 during the administration of Jimmy Carter.
Even moderate rates of inflation can shift wealth through the economy. Companies can make more money because their prices rise faster than wages. Households can also benefit as incomes eventually rise while costs on fixed-rate debt stay the same.
Chipotle Mexican Grill Inc. chief financial officer John Hartung told Bloomberg Television Oct. 22 that he expects inflation to be in the low-single to mid-single digits next year. “We would welcome modest inflation along with the continued pickup in consumer demand,” Hartung said.
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