Life at 0%

By Peter Coy

SOURCES Bank of America, Federal Reserve

If the U.S. economy were a disabled cruise ship, Barack Obama and Mitt Romney would be on the bridge arguing over who should take the wheel. Meanwhile, Chief Engineer Ben Bernanke, caked with soot, would be down in the engine room trying everything he could think of to get the ship restarted.

Under Bernanke’s chairmanship, the Federal Reserve has resorted to measures that are unprecedented in the bank’s 99-year history. It lowered its target interest rate as much as it could, from more than 5 percent in 2007 to between zero and 0.25 percent since 2008. It bought almost $2 trillion in long-term bonds. And it kept stretching out how long it intended to keep rates superlow. The latest target date, announced on Sept. 13, is at least through mid-2015, nearly eight years after the economy first tipped into recession. In a speech in Jackson Hole, Wyo., on Aug. 31, Bernanke conceded that the Fed is making it up as it goes along. He called this “the process of learning by doing.”

It would be nice to report that Bernanke’s hard-won lessons are doing the job. Mortgages, auto loans, and corporate borrowing costs are cheaper, it’s true, and the cost of servicing household debt is less than 11 percent of disposable income, compared with a peak of 14 percent in 2007. Mortgage prepayments are at a seven-year high. With income growing even more weakly than prices, lightening the debt burden has been crucial for consumer spending. And thanks in part to Bernankonomics, housing construction is finally adding to economic growth again instead of subtracting from it.

Yet it’s impossible to ignore that the economy is stuck in the longest period of high unemployment since the Great Depression. Why? Three things, mainly.

First, it takes a long time to recover from a financial crisis like the one that whacked the global economy in 2008-09. Second, the people in charge of taxing and spending — Congress and the White House — haven’t done their part. Businesses are postponing hiring and investment out of concern that Washington will bring on another recession by failing to prevent the tax increases and spending cuts that are scheduled to take effect in 2013.

The Fed itself is the third thing inhibiting the recovery. As much as he has done already, and it’s a lot, Bernanke needs to do more. Because for all of the rate-cutting and bond-buying, the central bank has so far failed to get businesses to resume investment, which is the key to hiring, income growth, and a self-sustaining economic recovery.

Columbia University’s Michael Woodford, one of the world’s foremost monetary economists, laid out a plan for what it would take at the same Jackson Hole conference at which Bernanke confessed his learning curve. In a paper called Methods of Policy Accommodation at the Interest-Rate Lower Bound, Woodford said the key to getting businesses to expand and consumers to spend is to change expectations about the long term. Businesses are hoarding cash because it’s costless to do so, and they have little confidence that demand will grow enough to make investment worthwhile. The solution, Woodford said, is to change chief executive officers’ minds about the future by committing to keeping interest rates extremely low long after the recovery has regained speed. He would keep pressing until the dollar value of the economy’s output reaches a target level, however long that takes.

Getting to Woodford’s target for the dollar value of gross domestic product can come about through an increase in output, an increase in prices, or a combination of the two. Which way the target is reached doesn’t matter: If business managers think inflation is coming, they will want to turn their cash into real assets before the pile is eroded by inflation. If they expect more real growth and choose to invest to capitalize on it, all the better. Either way, setting a higher target for what economists call “nominal gross domestic product” will induce businesses to invest now.

Woodford and Bernanke aren' t strangers. The two co-edited a book on inflation-targeting in 2003. In an Oct. 1 speech in Indianapolis that may have shown Woodford’s influence, the chairman said he expected money to remain easy “for a considerable time after the economy strengthens.”

Still, it’s hard to imagine Bernanke committing to a policy that could result in several years of inflation above the Fed’s current target of 2 percent, let alone sticking to that pledge when inflation actually pops up. It could seem downright irresponsible. Bernanke already faces pushback from hawks on the Federal Open Market Committee as well as from retirees who are suffering from basement-level yields on their savings. In Indianapolis he pointed out that “only a strong economy can create higher asset values and sustainably good returns for savers.”

Bernanke has earned a reputation as the most responsible policymaker in Washington. But when the economy is caught in a liquidity trap and needs a jolt, responsibility isn’t all it’s cracked up to be. As Paul Krugman observed in a paper in 1998, with Japan rather than the U.S. in mind, “Monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible.” Bernanke has shown he’s willing to be bold and inventive. Yet committing the Fed now to accepting a period of uncomfortably high inflation in the future might create more turbulence than the chief mechanic can stomach.


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