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Ben Bernanke's End Game

Ben Bernanke's End Game

Ben S. Bernanke speaks during a Brookings Institution discussion in Washington, D.C., Sept. 12.

Ben S. Bernanke speaks during a Brookings Institution discussion in Washington, D.C., Sept. 12.


Photo:

Zach Gibson/Bloomberg News

Ten years after the financial panic, the architects of the rescue policies are taking a victory lap. We won’t relitigate the immediate panic response, some of which we supported. But there is one policy whose outcome is still uncertain: The Federal Reserve’s near-decade of unprecedented zero-interest rates and bond buying. Is the October correction in stocks, including Wednesday’s 3% plunge, telling us that this bill is now coming due?

The final payments on any Fed monetary cycle aren’t merely the results when interest rates are low and policy is easy. The verdict is clear only at the end of the cycle when the Fed has to unwind its accommodation and interest rates rise. Only then can the world see clearly whether the Fed overdid its stimulus with nasty consequences on the other end.

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That’s true even in a conventional monetary cycle of falling and then rising interest rates. Thus only amid the housing bust that triggered the 2008 panic did we see the results of the Fed having kept interest rates too low for too long from 2003 through mid-decade.

Negative real interest rates produced a credit subsidy that fed a commodity boom and housing mania that eventually became a panic and crash. Former Fed chairs Ben Bernanke and Alan Greenspan to this day blame everyone else—“global imbalances”—but they should reread Charles Kindleberger: “The cycle of manias and panics results from the pro-cyclical changes in the supply of credit.”

This is especially true in the current monetary cycle because of the Fed’s post-2008 ministrations. The Bernanke Fed’s bond buying known as quantitative easing (QE) was aimed deliberately at holding down long-term interest rates. The goal of this “financial repression” was to push investors into riskier assets than Treasurys or bank accounts. The risk assets include equities that have had an extraordinary run since 2009 even as the real economy grew only moderately until 2017.

But since tax reform and deregulation reversed Barack Obama’s policies, the real economy has surged and is now growing at close to 4%. The Fed is lifting rates in response and belatedly (if slowly) winding down its bond buying. Bond yields are now rising in response to this faster growth, and traditionally that has meant that stock prices will fall.

The question that no one can answer with certainty is whether the correction in asset prices will be longer and deeper because the Fed’s financial repression was so extended. Some of our friends think it is irrelevant and that higher corporate earnings and faster growth will carry stocks to new heights, give or take the occasional adjustment. We hope they’re right.

But an honest assessment has to be that no one knows. We have never seen the kind of central bank experiment that Mr. Bernanke began and that Europe and Japan followed. It’s certainly possible that as long bond rates rise, capital will flow out of certain risk assets and back to a more normal pattern of investment allocation and risk.

No one knows, too, how much such a reversal will affect the real economy. Growth and overall economic confidence are strong enough now that even a major stock correction may not get in the way. Then again, if the “wealth effect” of rising 401(k)s and stock prices contributed to consumer confidence on the way up, perhaps it will subtract on the way down.

Keynesian economists also worry about what happens when government spending is scheduled to slow after 2019, but this underestimates the supply-side impact from the incentive changes of tax reform. Unless Democrats take Congress in November and reverse reform, or Mr. Trump’s trade war escalates, a recession doesn’t seem imminent.

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All of this leaves current Fed Chairman Jerome Powell with some difficult decisions. But no one should think that this end game will be his legacy alone. Mr. Powell and the current Fed inherited this clean-up operation after the long QE and zero-interest rate era.

Mr. Bernanke had begun only very modest tapering in Fed bond buying by the time he left the Fed in 2014. Janet Yellen succeeded him and began raising rates off zero very slowly with a similarly slow bond taper. Their legacies are as much on the line as Mr. Powell’s as the Fed steers through the end of this era of financial repression and toward a more complete verdict on post-crisis monetary policy.

The good news is that, thanks to the Trump-GOP policy mix, the economy is strong. The economic gains from faster growth, rising productivity and a tight labor market are also likely to flow more broadly than they did from the bull market in equities of the repression era. But as stock prices are showing, the transition is uncertain and may be bumpy.

Appeared in the October 11, 2018, print edition.

Published at Wed, 10 Oct 2018 22:56:32 +0000