Bernanke’s Speech Has the Market Buzzing with QE3 Hopes

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Fed Chairman Ben Bernanke, shown speaking at conference in March, is the subject of new criticism by Nobel prize-winning economist Paul Krugman, who accuses the central banker of not moving aggressively enough to help spur growth and lower unemployment.

The U.S. economy needs to grow faster to maintain job market momentum, Federal Reserve Chairman Ben Bernanke said in a speech Monday; as a result, the Fed will continue its low-interest rate policy, hoping to spur consumer demand and business investment. Stocks rose on Bernanke’s comments, with some on Wall Street reading hints about a third round of Fed bond purchases, or quantitative easing (QE3).

Despite encouraging signs, the labor market still has a very long way to go to get back to pre-recession levels. Two years of consistent but modest job gains have brought the unemployment rate from over 9% down to 8.3%. But the U.S. economy is still 5 million jobs short of the previous peak, Bernanke said, and three percentage points above the average unemployment rate for the last two decades.

“Further significant improvements in the unemployment rate will likely require a more rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies,” Bernanke said in a speech to the National Association for Business Economics.

Bernanke spent much of his speech addressing a puzzle that was highlighted by TIME’s Rana Foroohar last week: Unemployment has been falling even as economic growth has been tepid, apparently breaking the widely accepted economic principle known as Okun’s Law, which holds that the economy must grow above its potential to reduce the unemployment rate. (For example, if the potential rate of growth in the U.S. economy is 2%, we need annual growth of 4% to reduce the unemployment rate by 1%.) In fact, the economy grew by less than 2% last year, and yet the jobless rate fell by about 1%.

(More: Why Is Unemployment Falling So Fast When Growth Is So Slow?)

The Fed chairman addressed a number of possible explanations for this “apparent failure of Okun’s law,” as he put it,┬áincluding faulty growth estimates and misleading unemployment figures, before settling on what he called the most likely explanation: The better-than-expected jobless numbers are a result of employers playing “catch-up from outsized job losses during and just after the recession.” In other words, because the financial crisis was so dramatic, employers may have gone overboard in shedding workers — perhaps, as Bernanke explains, “because they feared an even more severe contraction to come or, with credit availability sharply curtailed, they were trying to conserve available cash.”

“What we may be seeing now is the flip side of the fear-driven layoffs that occurred during the worst part of the recession, as firms have become sufficiently confident to move their workforces into closer alignment with the expected demand for their products,” Bernanke said. If this is the case, it suggests that once this “catch-up” has been completed, the economy will revert to Okun’s Law-style behavior, which means that stronger growth will again be needed to maintain and increase the gains in the labor market.

This “reversal” — or bounce-back — from the outsized job losses during the recession is the essence of Bernanke’s argument, and the rationale for continued expansionary monetary policy, and possibly QE3 (though he didn’t explicitly call for it). “To the extent that this reversal has been completed,” Bernkanke said, “further significant improvements in the unemployment rate will likely require a more-rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies.”

Wall Street surged Monday as investors read the tea leaves of Bernanke’s speech to suggest that a further round of quantitative easing may be forthcoming. The Fed has already spent $2.3 trillion in two rounds to buy bonds in an effort to inject more money into the economy and spur growth (the second round concludes in June). In a Twitter message, Bill Gross, founder of bond giant PIMCO, wrote that the Fed “will probably hint at a third round of quantitative easing when policymakers meet in April.”

Critics of this policy argue that yet another round of quantitative easing could cause inflation to rise, but Bernanke, ever the economic historian, seems intent on not reversing the Fed’s easy-money policy too quickly — a mistake he believes policy-makers made during the Great Depression when they raised interest rates too soon, prolonging the road to recovery.