Fed Chair Bernanke Gives a History Lesson

By Pam Martens: July 11, 2013 

Ben Bernanke, Chairman of the Federal Reserve Board

The Federal Reserve used to manage its future monetary policy in bare whispers; under Chairman Ben Bernanke of late, it’s been lightning bolts of declarative statements that send the stock and bond markets careening in one direction and then another. 

In June, Bernanke said the Fed might begin later this year to taper downward its monthly purchases of $85 billion of Treasury and mortgage-backed securities, signaling the beginning of the end of cheap money. While Bernanke did at the time mention economic caveats before this tapering would begin, the markets heard only the lightning bolt of an end to easing and sold off in short order. 

Bernanke was out on the stump again yesterday, delivering a 4,000-word speech to the National Bureau of Economic Research at the Royal Sonesta Hotel in Cambridge, Massachusetts. This time, Bernanke delivered a history lesson on the Fed and curtailed his remarks on current policy to a reassurance that low interest rates would prevail until unemployment came down to at least the 6.5 percent range; he called that range a “threshold not a trigger” to alter policy. 

Unemployment is currently at 7.6 percent, a rate that Bernanke correctly noted yesterday is likely understating the depths of the problem.  Millions of Americans are working part-time because they can’t obtain full time employment and millions more have dropped out of seeking employment because of discouragement.  

After detailing the creation of the Fed and its following nine decades, Bernanke had the following to say about the current era:

“It has been about six years since the first signs of the financial crisis appeared in the United States, and we are still working to achieve a full recovery from its effects. What lessons should we take for the future from this experience, particularly in the context of a century of Federal Reserve history?

“The financial crisis and the ensuing Great Recession reminded us of a lesson that we learned both in the 19th century and during the Depression but had forgotten to some extent, which is that severe financial instability can do grave damage to the broader economy. The implication is that a central bank must take into account risks to financial stability if it is to help achieve good macroeconomic performance. Today, the Federal Reserve sees its responsibilities for the maintenance of financial stability as coequal with its responsibilities for the management of monetary policy, and we have made substantial institutional changes in recognition of this change in goals. In a sense, we have come full circle, back to the original goal of the Federal Reserve of preventing financial panics.

“How should a central bank enhance financial stability? One means is by assuming the lender-of-last-resort function that Bagehot understood and described 140 years ago, under which the central bank uses its power to provide liquidity to ease market conditions during periods of panic or incipient panic. The Fed’s many liquidity programs played a central role in containing the crisis of 2008 to 2009. However, putting out the fire is not enough; it is also important to foster a financial system that is sufficiently resilient to withstand large financial shocks. Toward that end, the Federal Reserve, together with other regulatory agencies and the Financial Stability Oversight Council, is actively engaged in monitoring financial developments and working to strengthen financial institutions and markets. The reliance on stronger regulation is informed by the success of New Deal regulatory reforms, but current reform efforts go even further by working to identify and defuse risks not only to individual firms but to the financial system as a whole, an approach known as macro-prudential regulation.

“Financial stability is also linked to monetary policy, though these links are not yet fully understood. Here the Fed’s evolving strategy is to make monitoring, supervision, and regulation the first line of defense against systemic risks; to the extent that risks remain, however, the FOMC strives to incorporate these risks in the cost-benefit analysis applied to all monetary policy actions.

“What about the monetary policy framework? In general, the Federal Reserve’s policy framework inherits many of the elements put in place during the Great Moderation. These features include the emphasis on preserving the Fed’s inflation credibility, which is critical for anchoring inflation expectations, and a balanced approach in pursuing both parts of the Fed’s dual mandate in the medium term. We have also continued to increase the transparency of monetary policy. For example, the Committee’s communications framework now includes a statement of its longer-run goals and monetary policy strategy.  In that statement, the Committee indicated that it judged that inflation at a rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures) is most consistent over the longer run with the FOMC’s dual mandate. FOMC participants also regularly provide estimates of the longer-run normal rate of unemployment; those estimates currently have a central tendency of 5.2 to 6.0 percent. By helping to anchor longer-term expectations, this transparency gives the Federal Reserve greater flexibility to respond to short-run developments. This framework, which combines short-run policy flexibility with the discipline provided by the announced targets, has been described as constrained discretion.  Other communication innovations include early publication of the minutes of FOMC meetings and quarterly post-meeting press conferences by the Chairman.

“The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following the ideas of Lars Svensson and others, the FOMC has moved toward a framework that ties policy settings more directly to the economic outlook, a so-called forecast-based approach.  In particular, the FOMC has released more detailed statements following its meetings that have related the outlook for policy to prospective economic developments and has introduced regular summaries of the individual economic projections of FOMC participants (including for the target federal funds rate). The provision of additional information about policy plans has helped Fed policymakers deal with the constraint posed by the effective lower bound on short-term interest rates; in particular, by offering guidance about how policy will respond to economic developments, the Committee has been able to increase policy accommodation, even when the short-term interest rate is near zero and cannot be meaningfully reduced further.  The Committee has also sought to influence interest rates further out on the yield curve, notably through its securities purchases. Other central banks in advanced economies, also confronted with the effective lower bound on short-term interest rates, have taken similar measures.

“In short, the recent crisis has underscored the need both to strengthen our monetary policy and financial stability frameworks and to better integrate the two. We have made progress on both counts, but more needs to be done. In particular, the complementarities among regulatory and supervisory policies (including macro-prudential policy), lender-of-last-resort policy, and standard monetary policy are increasingly evident. Both research and experience are needed to help the Fed and other central banks develop comprehensive frameworks that incorporate all of these elements. The broader conclusion is what might be described as the overriding lesson of the Federal Reserve’s history: that central banking doctrine and practice are never static. We and other central banks around the world will have to continue to work hard to adapt to events, new ideas, and changes in the economic and financial environment.”

One statement stands out from all the rest in this speech: “The reliance on stronger regulation is informed by the success of New Deal regulatory reforms, but current reform efforts go even further by working to identify and defuse risks not only to individual firms but to the financial system as a whole, an approach known as macro-prudential regulation.”

Nothing that Bernanke said could be further from the truth than the idea that today’s Wall Street reform bears any resemblance to the Glass-Steagall Act imposed in the New Deal era. The Dodd-Frank financial reform legislation of today has left Wall Street casino operations attached at the hip to insured depository banks; it has left trading for the house (proprietary trading) in place using insured deposits; it has left hundreds of trillions of dollars in risky derivatives off the balance sheets of the too-big-to-fail banks; and it has put the Federal Reserve Bank of New York, whose Board is infused with financial executives, in charge of regulating the holding companies of these Frankenbanks.

Monetary policy is no longer the sole mandate of the Fed; under this disfigured and dysfunctional era of financial reform, the Fed is now not just the lender of last resort but the regulator of last resort. That is a perversion of logic that has, and will continue to, cost this country dearly.

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