Five Questions about the Federal Reserve and Monetary Policy, Speech, Chairman
Ben S. Bernanke, At the Economic Club of Indiana, Indianapolis, Indiana, October
1, 2012: Good afternoon. I am pleased to be able to join the Economic Club
of Indiana for lunch today. I note that the mission of the club is "to promote
an interest in, and enlighten its membership on, important governmental,
economic and social issues." I hope my remarks today will meet that standard.
Before diving in, I'd like to thank my former colleague at the White House, Al
Hubbard, for helping to make this event possible. As the head of the National
Economic Council under President Bush, Al had the difficult task of making sure
that diverse perspectives on economic policy issues were given a fair hearing
before recommendations went to the President. Al had to be a combination of
economist, political guru, diplomat, and traffic cop, and he handled it with
great skill.
My topic today is "Five Questions about the Federal Reserve and Monetary
Policy." I have used a question-and-answer format in talks before, and I know
from much experience that people are eager to know more about the Federal
Reserve, what we do, and why we do it. And that interest is even broader than
one might think. I'm a baseball fan, and I was excited to be invited to a recent
batting practice of the playoff-bound Washington Nationals. I was introduced to
one of the team's star players, but before I could press my questions on some
fine points of baseball strategy, he asked, "So, what's the scoop on
quantitative easing?" So, for that player, for club members and guests here
today, and for anyone else curious about the Federal Reserve and monetary
policy, I will ask and answer these five questions:
- What are the Fed's objectives, and how is it trying to meet them?
- What's the relationship between the Fed's monetary policy and the fiscal
decisions of the Administration and the Congress?
- What is the risk that the Fed's accommodative monetary policy will lead
to inflation?
- How does the Fed's monetary policy affect savers and investors?
- How is the Federal Reserve held accountable in our democratic society?
What Are the Fed's Objectives, and How Is It Trying to Meet Them?
The first question on my list concerns the Federal Reserve's objectives and the
tools it has to try to meet them.
As the nation's central bank, the Federal Reserve is charged with promoting a
healthy economy--broadly speaking, an economy with low unemployment, low and
stable inflation, and a financial system that meets the economy's needs for
credit and other services and that is not itself a source of instability. We
pursue these goals through a variety of means. Together with other federal
supervisory agencies, we oversee banks and other financial institutions. We
monitor the financial system as a whole for possible risks to its stability. We
encourage financial and economic literacy, promote equal access to credit, and
advance local economic development by working with communities, nonprofit
organizations, and others around the country. We also provide some basic
services to the financial sector--for example, by processing payments and
distributing currency and coin to banks.
But today I want to focus on a role that is particularly identified with the
Federal Reserve--the making of monetary policy. The goals of monetary
policy--maximum employment and price stability--are given to us by the Congress.
These goals mean, basically, that we would like to see as many Americans as
possible who want jobs to have jobs, and that we aim to keep the rate of
increase in consumer prices low and stable.
In normal circumstances, the Federal Reserve implements monetary policy
through its influence on short-term interest rates, which in turn affect other
interest rates and asset prices.1 Generally, if economic weakness is
the primary concern, the Fed acts to reduce interest rates, which supports the
economy by inducing businesses to invest more in new capital goods and by
leading households to spend more on houses, autos, and other goods and services.
Likewise, if the economy is overheating, the Fed can raise interest rates to
help cool total demand and constrain inflationary pressures.
Following this standard approach, the Fed cut short-term interest rates
rapidly during the financial crisis, reducing them to nearly zero by the end of
2008--a time when the economy was contracting sharply. At that point, however,
we faced a real challenge: Once at zero, the short-term interest rate could not
be cut further, so our traditional policy tool for dealing with economic
weakness was no longer available. Yet, with unemployment soaring, the economy
and job market clearly needed more support. Central banks around the world found
themselves in a similar predicament. We asked ourselves, "What do we do now?"
To answer this question, we could draw on the experience of Japan, where
short-term interest rates have been near zero for many years, as well as a good
deal of academic work. Unable to reduce short-term interest rates further, we
looked instead for ways to influence longer-term interest rates, which remained
well above zero. We reasoned that, as with traditional monetary policy, bringing
down longer-term rates should support economic growth and employment by lowering
the cost of borrowing to buy homes and cars or to finance capital investments.
Since 2008, we've used two types of less-traditional monetary policy tools to
bring down longer-term rates.
The first of these less-traditional tools involves the Fed purchasing
longer-term securities on the open market--principally Treasury securities and
mortgage-backed securities guaranteed by government-sponsored enterprises such
as Fannie Mae and Freddie Mac. The Fed's purchases reduce the amount of
longer-term securities held by investors and put downward pressure on the
interest rates on those securities. That downward pressure transmits to a wide
range of interest rates that individuals and businesses pay. For example, when
the Fed first announced purchases of mortgage-backed securities in late 2008,
30-year mortgage interest rates averaged a little above 6percent; today they
average about 3-1/2 percent. Lower mortgage rates are one reason for the
improvement we have been seeing in the housing market, which in turn is
benefiting the economy more broadly. Other important interest rates, such as
corporate bond rates and rates on auto loans, have also come down. Lower
interest rates also put upward pressure on the prices of assets, such as stocks
and homes, providing further impetus to household and business spending.
The second monetary policy tool we have been using involves communicating our
expectations for how long the short-term interest rate will remain exceptionally
low. Because the yield on, say, a five-year security embeds market expectations
for the course of short-term rates over the next five years, convincing
investors that we will keep the short-term rate low for a longer time can help
to pull down market-determined longer-term rates. In sum, the Fed's basic
strategy for strengthening the economy--reducing interest rates and easing
financial conditions more generally--is the same as it has always been. The
difference is that, with the short-term interest rate nearly at zero, we have
shifted to tools aimed at reducing longer-term interest rates more directly.
Last month, my colleagues and I used both tools--securities purchases and
communications about our future actions--in a coordinated way to further support
the recovery and the job market. Why did we act? Though the economy has been
growing since mid-2009 and we expect it to continue to expand, it simply has not
been growing fast enough recently to make significant progress in bringing down
unemployment. At 8.1 percent, the unemployment rate is nearly unchanged since
the beginning of the year and is well above normal levels. While unemployment
has been stubbornly high, our economy has enjoyed broad price stability for some
time, and we expect inflation to remain low for the foreseeable future. So the
case seemed clear to most of my colleagues that we could do more to assist
economic growth and the job market without compromising our goal of price
stability.
Specifically, what did we do? On securities purchases, we announced that we
would buy mortgage-backed securities guaranteed by the government-sponsored
enterprises at a rate of $40 billion per month. Those purchases, along with the
continuation of a previous program involving Treasury securities, mean we are
buying $85 billion of longer-term securities per month through the end of the
year. We expect these purchases to put further downward pressure on longer-term
interest rates, including mortgage rates. To underline the Federal Reserve's
commitment to fostering a sustainable economic recovery, we said that we would
continue securities purchases and employ other policy tools until the outlook
for the job market improves substantially in a context of price stability.
In the category of communications policy, we also extended our estimate of
how long we expect to keep the short-term interest rate at exceptionally low
levels to at least mid-2015. That doesn't mean that we expect the economy to be
weak through 2015. Rather, our message was that, so long as price stability is
preserved, we will take care not to raise rates prematurely. Specifically, we
expect that a highly accommodative stance of monetary policy will remain
appropriate for a considerable time after the economy strengthens. We hope that,
by clarifying our expectations about future policy, we can provide individuals,
families, businesses, and financial markets greater confidence about the Federal
Reserve's commitment to promoting a sustainable recovery and that, as a result,
they will become more willing to invest, hire and spend.
Now, as I have said many times, monetary policy is no panacea. It can be used
to support stronger economic growth in situations in which, as today, the
economy is not making full use of its resources, and it can foster a healthier
economy in the longer term by maintaining low and stable inflation. However,
many other steps could be taken to strengthen our economy over time, such as
putting the federal budget on a sustainable path, reforming the tax code,
improving our educational system, supporting technological innovation, and
expanding international trade. Although monetary policy cannot cure the
economy's ills, particularly in today's challenging circumstances, we do think
it can provide meaningful help. So we at the Federal Reserve are going to do
what we can do and trust that others, in both the public and private sectors,
will do what they can as well.
What's the Relationship between Monetary Policy and Fiscal Policy?
That brings me to the second question: What's the relationship between monetary
policy and fiscal policy? To answer this question, it may help to begin with the
more basic question of how monetary and fiscal policy differ.
In short, monetary policy and fiscal policy involve quite different sets of
actors, decisions, and tools. Fiscal policy involves decisions about how much
the government should spend, how much it should tax, and how much it should
borrow. At the federal level, those decisions are made by the Administration and
the Congress. Fiscal policy determines the size of the federal budget deficit,
which is the difference between federal spending and revenues in a year.
Borrowing to finance budget deficits increases the government's total
outstanding debt.
As I have discussed, monetary policy is the responsibility of the Federal
Reserve--or, more specifically, the Federal Open Market Committee, which
includes members of the Federal Reserve's Board of Governors and presidents of
Federal Reserve Banks. Unlike fiscal policy, monetary policy does not involve
any taxation, transfer payments, or purchases of goods and services. Instead, as
I mentioned, monetary policy mainly involves the purchase and sale of
securities. The securities that the Fed purchases in the conduct of monetary
policy are held in our portfolio and earn interest. The great bulk of these
interest earnings is sent to the Treasury, thereby helping reduce the government
deficit. In the past three years, the Fed remitted $200 billion to the federal
government. Ultimately, the securities held by the Fed will mature or will be
sold back into the market. So the odds are high that the purchase programs that
the Fed has undertaken in support of the recovery will end up reducing, not
increasing, the federal debt, both through the interest earnings we send the
Treasury and because a stronger economy tends to lead to higher tax revenues and
reduced government spending (on unemployment benefits, for example).
Even though our activities are likely to result in a lower national debt over
the long term, I sometimes hear the complaint that the Federal Reserve is
enabling bad fiscal policy by keeping interest rates very low and thereby making
it cheaper for the federal government to borrow. I find this argument
unpersuasive. The responsibility for fiscal policy lies squarely with the
Administration and the Congress. At the Federal Reserve, we implement policy to
promote maximum employment and price stability, as the law under which we
operate requires. Using monetary policy to try to influence the political debate
on the budget would be highly inappropriate. For what it's worth, I think the
strategy would also likely be ineffective: Suppose, notwithstanding our legal
mandate, the Federal Reserve were to raise interest rates for the purpose of
making it more expensive for the government to borrow. Such an action would
substantially increase the deficit, not only because of higher interest rates,
but also because the weaker recovery that would result from premature monetary
tightening would further widen the gap between spending and revenues. Would such
a step lead to better fiscal outcomes? It seems likely that a significant
widening of the deficit--which would make the needed fiscal actions even more
difficult and painful--would worsen rather than improve the prospects for a
comprehensive fiscal solution.
I certainly don't underestimate the challenges that fiscal policymakers face.
They must find ways to put the federal budget on a sustainable path, but not so
abruptly as to endanger the economic recovery in the near term. In particular,
the Congress and the Administration will soon have to address the so-called
fiscal cliff, a combination of sharply higher taxes and reduced spending that is
set to happen at the beginning of the year. According to the Congressional
Budget Office and virtually all other experts, if that were allowed to occur, it
would likely throw the economy back into recession. The Congress and the
Administration will also have to raise the debt ceiling to prevent the Treasury
from defaulting on its obligations, an outcome that would have extremely
negative consequences for the country for years to come. Achieving these fiscal
goals would be even more difficult if monetary policy were not helping support
the economic recovery.
What Is the Risk that the Federal Reserve's Monetary Policy Will Lead
to Inflation?
A third question, and an important one, is whether the Federal Reserve's
monetary policy will lead to higher inflation down the road. In response, I will
start by pointing out that the Federal Reserve's price stability record is
excellent, and we are fully committed to maintaining it. Inflation has averaged
close to 2 percent per year for several decades, and that's about where it is
today. In particular, the low interest rate policies the Fed has been following
for about five years now have not led to increased inflation. Moreover,
according to a variety of measures, the public's expectations of inflation over
the long run remain quite stable within the range that they have been for many
years.
With monetary policy being so accommodative now, though, it is not
unreasonable to ask whether we are sowing the seeds of future inflation. A
related question I sometimes hear--which bears also on the relationship between
monetary and fiscal policy, is this: By buying securities, are you "monetizing
the debt"--printing money for the government to use--and will that inevitably
lead to higher inflation? No, that's not what is happening, and that will not
happen. Monetizing the debt means using money creation as a permanent source of
financing for government spending. In contrast, we are acquiring Treasury
securities on the open market and only on a temporary basis, with the goal of
supporting the economic recovery through lower interest rates. At the
appropriate time, the Federal Reserve will gradually sell these securities or
let them mature, as needed, to return its balance sheet to a more normal size.
Moreover, the way the Fed finances its securities purchases is by creating
reserves in the banking system. Increased bank reserves held at the Fed don't
necessarily translate into more money or cash in circulation, and, indeed, broad
measures of the supply of money have not grown especially quickly, on balance,
over the past few years.
For controlling inflation, the key question is whether the Federal Reserve
has the policy tools to tighten monetary conditions at the appropriate time so
as to prevent the emergence of inflationary pressures down the road. I'm
confident that we have the necessary tools to withdraw policy accommodation when
needed, and that we can do so in a way that allows us to shrink our balance
sheet in a deliberate and orderly way. For example, the Fed can tighten policy,
even if our balance sheet remains large, by increasing the interest rate we pay
banks on reserve balances they deposit at the Fed. Because banks will not lend
at rates lower than what they can earn at the Fed, such an action should serve
to raise rates and tighten credit conditions more generally, preventing any
tendency toward overheating in the economy.
Of course, having effective tools is one thing; using them in a timely way,
neither too early nor too late, is another. Determining precisely the right time
to "take away the punch bowl" is always a challenge for central bankers, but
that is true whether they are using traditional or nontraditional policy tools.
I can assure you that my colleagues and I will carefully consider how best to
foster both of our mandated objectives, maximum employment and price stability,
when the time comes to make these decisions.
How Does the Fed's Monetary Policy Affect Savers and Investors?
The concern about possible inflation is a concern about the future. One concern
in the here and now is about the effect of low interest rates on savers and
investors. My colleagues and I know that people who rely on investments that pay
a fixed interest rate, such as certificates of deposit, are receiving very low
returns, a situation that has involved significant hardship for some.
However, I would encourage you to remember that the current low levels of
interest rates, while in the first instance a reflection of the Federal
Reserve's monetary policy, are in a larger sense the result of the recent
financial crisis, the worst shock to this nation's financial system since the
1930s. Interest rates are low throughout the developed world, except in
countries experiencing fiscal crises, as central banks and other policymakers
try to cope with continuing financial strains and weak economic conditions.
A second observation is that savers often wear many economic hats. Many
savers are also homeowners; indeed, a family's home may be its most important
financial asset. Many savers are working, or would like to be. Some savers own
businesses, and--through pension funds and 401(k) accounts--they often own
stocks and other assets. The crisis and recession have led to very low interest
rates, it is true, but these events have also destroyed jobs, hamstrung economic
growth, and led to sharp declines in the values of many homes and businesses.
What can be done to address all of these concerns simultaneously? The best and
most comprehensive solution is to find ways to a stronger economy. Only a strong
economy can create higher asset values and sustainably good returns for savers.
And only a strong economy will allow people who need jobs to find them. Without
a job, it is difficult to save for retirement or to buy a home or to pay for an
education, irrespective of the current level of interest rates.
The way for the Fed to support a return to a strong economy is by maintaining
monetary accommodation, which requires low interest rates for a time. If, in
contrast, the Fed were to raise rates now, before the economic recovery is fully
entrenched, house prices might resume declines, the values of businesses large
and small would drop, and, critically, unemployment would likely start to rise
again. Such outcomes would ultimately not be good for savers or anyone else.
How Is the Federal Reserve Held Accountable in a Democratic Society?
I will turn, finally, to the question of how the Federal Reserve is held
accountable in a democratic society.
The Federal Reserve was created by the Congress, now almost a century ago. In
the Federal Reserve Act and subsequent legislation, the Congress laid out the
central bank's goals and powers, and the Fed is responsible to the Congress for
meeting its mandated objectives, including fostering maximum employment and
price stability. At the same time, the Congress wisely designed the Federal
Reserve to be insulated from short-term political pressures. For example,
members of the Federal Reserve Board are appointed to staggered, 14-year terms,
with the result that some members may serve through several Administrations.
Research and practical experience have established that freeing the central bank
from short-term political pressures leads to better monetary policy because it
allows policymakers to focus on what is best for the economy in the longer run,
independently of near-term electoral or partisan concerns. All of the members of
the Federal Open Market Committee take this principle very seriously and strive
always to make monetary policy decisions based solely on factual evidence and
careful analysis.
It is important to keep politics out of monetary policy decisions, but it is
equally important, in a democracy, for those decisions--and, indeed, all of the
Federal Reserve's decisions and actions--to be undertaken in a strong framework
of accountability and transparency. The American people have a right to know how
the Federal Reserve is carrying out its responsibilities and how we are using
taxpayer resources.
One of my principal objectives as Chairman has been to make monetary policy
at the Federal Reserve as transparent as possible. We promote policy
transparency in many ways. For example, the Federal Open Market Committee
explains the reasons for its policy decisions in a statement released after each
regularly scheduled meeting, and three weeks later we publish minutes with a
detailed summary of the meeting discussion. The Committee also publishes
quarterly economic projections with information about where we anticipate both
policy and the economy will be headed over the next several years. I hold news
conferences four times a year and testify often before congressional committees,
including twice-yearly appearances that are specifically designated for the
purpose of my presenting a comprehensive monetary policy report to the Congress.
My colleagues and I frequently deliver speeches, such as this one, in towns and
cities across the country.
The Federal Reserve is also very open about its finances and operations. The
Federal Reserve Act requires the Federal Reserve to report annually on its
operations and to publish its balance sheet weekly. Similarly, under the
financial reform law enacted after the financial crisis, we publicly report in
detail on our lending programs and securities purchases, including the
identities of borrowers and counterparties, amounts lent or purchased, and other
information, such as collateral accepted. In late 2010, we posted detailed
information on our public website about more than 21,000 individual credit and
other transactions conducted to stabilize markets during the financial crisis.
And, just last Friday, we posted the first in an ongoing series of quarterly
reports providing a great deal of information on individual discount window
loans and securities transactions. The Federal Reserve's financial statement is
audited by an independent, outside accounting firm, and an independent Inspector
General has wide powers to review actions taken by the Board. Importantly, the
Government Accountability Office (GAO) has the ability to--and does--oversee the
efficiency and integrity of all of our operations, including our financial
controls and governance.
While the GAO has access to all aspects of the Fed's operations and is free
to criticize or make recommendations, there is one important exception: monetary
policymaking. In the 1970s, the Congress deliberately excluded monetary policy
deliberations, decisions, and actions from the scope of GAO reviews. In doing
so, the Congress carefully balanced the need for democratic accountability with
the benefits that flow from keeping monetary policy free from short-term
political pressures.
However, there have been recent proposals to expand the authority of the GAO
over the Federal Reserve to include reviews of monetary policy decisions.
Because the GAO is the investigative arm of the Congress and GAO reviews may be
initiated at the request of members of the Congress, these reviews (or the
prospect of reviews) of individual policy decisions could be seen, with good
reason, as efforts to bring political pressure to bear on monetary policymakers.
A perceived politicization of monetary policy would reduce public confidence in
the ability of the Federal Reserve to make its policy decisions based strictly
on what is good for the economy in the longer term. Balancing the need for
accountability against the goal of insulating monetary policy from short-term
political pressure is very important, and I believe that the Congress had it
right in the 1970s when it explicitly chose to protect monetary policy decision
making from the possibility of politically motivated reviews.
Conclusion
In conclusion, I will simply note that these past few years have been a
difficult time for the nation and the economy. For its part, the Federal Reserve
has also been tested by unprecedented challenges. As we approach next year's
100th anniversary of the signing of the Federal Reserve Act, however, I have
great confidence in the institution. In particular, I would like to recognize
the skill, professionalism, and dedication of the employees of the Federal
Reserve System. They work tirelessly to serve the public interest and to promote
prosperity for people and businesses across America. The Fed's policy choices
can always be debated, but the quality and commitment of the Federal Reserve as
a public institution is second to none, and I am proud to lead it.
Now that I've answered questions that I've posed to myself, I'd be happy to
respond to yours.
1. The Fed has a number of ways to influence short-term rates; basically,
they involve steps to affect the supply, and thus the cost, of short-term
funding.
