THE BASIS POINT

Bernanke: “Some Way To Go” Before Self-Sustaining Economic Growth

Fed Chairman Bernanke spoke at the Economics Club of Washington today. Here’s the full speech, and below are key excerpts with subheads added by us. There’s an entire section of the speech devoted to ‘how to avoid crises in the future’ and it discusses proposed regulations. But below covers economic and inflation outlook as well as Fed exit strategy.

ECONOMIC OUTLOOK
…In the United States, the unemployment rate, which was as low as 4.4 percent in March 2007, currently stands at 10 percent.

…Though we have begun to see some improvement in economic activity, we still have some way to go before we can be assured that the recovery will be self-sustaining. Also at issue is whether the recovery will be strong enough to create the large number of jobs that will be needed to materially bring down the unemployment rate. Economic forecasts are subject to great uncertainty, but my best guess at this point is that we will continue to see modest economic growth next year–sufficient to bring down the unemployment rate, but at a pace slower than we would like.

…A number of factors support the view that the recovery will continue next year. Importantly, financial conditions continue to improve: Corporations are having relatively little difficulty raising funds in the bond and stock markets, stock prices and other asset values have recovered significantly from their lows, and a variety of indicators suggest that fears of systemic collapse have receded substantially. Monetary and fiscal policies are supportive. And I have already mentioned what appear to be improving conditions in housing, consumer expenditure, business investment, and global economic activity.

…On the other hand, the economy confronts some formidable headwinds that seem likely to keep the pace of expansion moderate. Despite the general improvement in financial conditions, credit remains tight for many borrowers, particularly bank-dependent borrowers such as households and small businesses. And the job market, though no longer contracting at the pace we saw in 2008 and earlier this year, remains weak. Household spending is unlikely to grow rapidly when people remain worried about job security and have limited access to credit.

FED POLICY
…The Federal Reserve has been, and still is, doing a great deal to foster financial stability and to spur recovery in jobs and economic activity. Notably, we began the process of easing monetary policy in September 2007, shortly after the crisis began. By mid-December 2008, our target rate was effectively as low as it could go–within a range of 0 to 1/4 percent, compared with 5-1/4 percent before the crisis–and we have maintained that very low rate for the past year.

…In all of these efforts, our objective has not been to support specific financial institutions or markets for their own sake. Rather, recognizing that a healthy economy requires well-functioning financial markets, we have moved always with the single aim of promoting economic recovery and economic opportunity. In that respect, our means and goals have been fully consistent with the traditional functions of a central bank and with the mandate given to the Federal Reserve by the Congress to promote price stability and maximum employment.

SUPPORT FOR NATIONAL FED SYSTEM
…In navigating through the crisis, the Federal Reserve has been greatly aided by the regional structure established by the Congress when it created the Federal Reserve in 1913. The more than 270 business people, bankers, nonprofit executives, academics, and community, agricultural, and labor leaders who serve on the boards of the 12 Reserve Banks and their 24 Branches provide valuable insights into current economic and financial conditions that statistics alone cannot. Thus, the structure of the Federal Reserve ensures that our policymaking is informed not just by a Washington perspective, or a Wall Street perspective, but also a Main Street perspective. Indeed, our Reserve Banks and Branches have deep roots in the nation’s communities and do much good work there. They have, to give just a couple of examples, assisted organizations specializing in foreclosure mitigation and worked with nonprofit groups to help stabilize neighborhoods hit by high rates of foreclosure. They (as well as the Board) are also much involved in financial and economic education, helping people to make better financial decisions and to better understand how the economy works.

INFLATION OUTLOOK
The scope and scale of our actions, however, while necessary and helpful in my view, have left some uneasy. In all, our asset purchases and lending have caused the Federal Reserve’s balance sheet to more than double, from less than $900 billion before the crisis began to about $2.2 trillion today. Unprecedented balance sheet expansion and near-zero overnight interest rates raise our third frequently asked question: Will the Federal Reserve’s actions to combat the crisis lead to higher inflation down the road?

The answer is no; the Federal Reserve is committed to keeping inflation low and will be able to do so. In the near term, elevated unemployment and stable inflation expectations should keep inflation subdued, and indeed, inflation could move lower from here. However, as the recovery strengthens, the time will come when it is appropriate to begin withdrawing the unprecedented monetary stimulus that is helping to support economic activity. For that reason, we have been giving careful thought to our exit strategy. We are confident that we have all the tools necessary to withdraw monetary stimulus in a timely and effective way.

FED EXIT STRATEGY
Indeed, our balance sheet is already beginning to adjust, because improving financial conditions are leading to substantially reduced use of our lending facilities. The balance sheet will also shrink over time as the mortgage-backed securities and other assets we hold mature or are prepaid. However, even if our balance sheet stays large for a while, we will be able to raise our target short-term interest rate–which is the rate at which banks lend to each other overnight–and thus tighten financial conditions appropriately.

Operationally, an important tool for adjusting the stance of monetary policy will be the authority, granted to us by the Congress last year, to pay banks interest on balances they hold at the Federal Reserve. When the time comes to raise short-term interest rates and thereby tighten policy, we can do so by raising the rate that we offer banks on their balances with us. Banks will be unwilling to make overnight loans to each other at a rate lower than the rate that they can earn risk-free from the Fed, and so the interest rate we pay on banks’ balances will tend to set a floor below our target overnight loan rate and other short-term interest rates.

Additional upward pressure on short-term interest rates can be achieved by measures to reduce the supply of funds that banks have available to lend to each other. We have a number of tools to accomplish this. For example, through the use of a short-term funding method known as reverse repurchase agreements, we can act directly to reduce the quantity of reserves held by the banking system. By paying a slightly higher rate of interest, we could induce banks to lock up their balances in longer-term accounts with us, making those balances unavailable for lending in the overnight market. And, if necessary, we always have the option of reducing the size of our balance sheet by selling some of our securities holdings on the open market.

As always, the most difficult challenge for the Federal Open Market Committee will not be devising the technical means of unwinding monetary stimulus. Rather, it will be the challenge that faces central banks in every economic recovery, which is correctly judging the best time to tighten policy. Because monetary policy affects the economy with a lag, we will need to base our decision on our best forecast of how the economy will develop. As I said a few moments ago, we currently expect inflation to remain subdued for some time. It is also reassuring that longer-term inflation expectations appear stable. Nevertheless, we will keep a close eye on inflation risks and will do whatever is necessary to meet our mandate to foster both price stability and maximum employment.