Ben Bernanke is playing chicken with the real economy.
By most measures, the U.S. economy in the past few months seems to be improving. The unemployment rate has been falling. Manufacturing appears to be perking up. U.S. car companies are back in business. And home sales even rose in December.
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Yet, on Wednesday, the U.S. central bank said it plans to keep short-term interest rates near zero until at least late 2014. That is 18 months longer than its previous promise of mid-2013. Low interest rates usually indicate the economy is weak. So a promise to keep interest rates low for another two and a half years, suggests that the Fed thinks the economy will be in pretty bad shape for, well, about another two and a half years. Or maybe not.
When Bernanke was pressed at the news conference following the Fed’s interest-rate announcement on why it chose late 2014 and not, say, 2015 or 2020 — after all, the Fed’s own prediction was that unemployment would still be at a high 7.5% in late 2014 — Bernanke didn’t have a good answer. He said the Fed’s ability to “forecast three or four years out is not very good.” But we didn’t need Bernanke to tell us that. We all know now how poor the Fed’s ability to predict the economy is. Recently released documents from Fed meetings back in 2007 show that almost none of the Fed’s policymakers thought we were headed for a recession at the time.
So why do it? Like many other things the Fed does, to help the markets. Promising low interest rates should help goose the stock and bond markets, and it did this time around as well. Shortly after the Fed made its announcement, both stocks and bonds rose. The question is whether it will have the opposite effect on the real economy.
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In a regular recession, lower interest rates cause people to borrow money to buy houses or start new businesses. In a really bad recession, like this one, that economic jump-start mechanism breaks down. People are too scared to take risks. Companies look for signs that the economy is back on the upswing before borrowing to expand. Confidence, not interest rates, is the real problem.
That’s why some people have been worried for a while about the signaling effect of keeping interest rates at zero. They are worried that the Fed is undermining confidence in the recovery. And even if they are not worried about the recovery, knowing interest rates will remain low may cause people to put off purchases. For instance, if you know interest rates are going to be low for another two years, why jump into the housing market now, when prices might still fall. But if you are afraid that interest rates will rise soon, you might be more likely to buy a house now in order to get a better deal on the loan. Bernanke’s critics say raising interest rates even a little bit would do more to help confidence than keeping interest rates low for another two years or more. Interest rates have been near zero for some time now. Anyone who wants to borrow has had their chance.
The problem is, with short-term interest rates already at zero, the Fed doesn’t have many options. So it is engaging in this weird dance of talking down the economy in order to boost the markets, hoping that the market will in turn boost the economy. It only works if the people in the real economy believe the market more than they believe the Fed. And I’m not sure that’s a great bet. My experience with bull markets is that the general public doesn’t notice them until they are well under way.
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There is another option for Bernanke, and that is for the Fed to once again use the government’s money to buy U.S. Treasury and mortgage bonds to directly drive down rates. This would also signal that the Fed thinks the economy is weak, but it would do so without an exact date. The problem with that is, the Fed came under massive criticism for its last round of bond buying. After all, taking the government’s money to buy up our own debt seems like financial alchemy. He was called the most inflationary Fed chief ever and a traitor by various GOP presidential candidates. But if Bernanke really wants to boost the economy, he will have to do things that will be unpopular, or more of them. When Paul Volcker raised interest rates to crush inflation, he was widely denounced. Now he is considered a monetary god. If Bernanke wants to be known as the guy who saved the economy, and not just avoided a depression, more bold steps will be needed.
