The Federal Reserve Bank's latest economic forecast, released last week, is dispiriting: Economic growth, already expected to be less than 4 percent for the year, was downgraded; the Fed now expects between 3 percent and 3.5 percent growth, spelling further employment woes. Critically, about half of the Fed's central policy-making unit, the Federal Open Market Committee, believes that the new forecast is too optimistic.
Today, Fed Chair Ben Bernanke appears before the Senate to offer his semiannual report on monetary policy. It is a key moment for the central banker: The debate over his institution's decision making has reached a fever pitch, with many liberals urging the Fed to take further measures to bolster the economy while most conservatives fret over the size of the Fed's balance sheet and fear rising interest rates and inflation. This debate is also raging inside the Fed, as the split FOMC shows.
At the hearing, Bernanke will have to justify his middle course between the inflation hawks and Fed directors pressing for more action: keeping interest rates at zero for the foreseeable future -- the limit of conventional monetary policy -- and promising to carefully watch economic conditions. The indicators aren't looking good on either side of the Fed's dual mandate to maintain low inflation and maximum employment: Deflation worries are increasing as inflation drops to less than 1 percent, the lowest level in 44 years, while unemployment looks to hover around 10 percent for at least another year.
Both of these trends are trouble -- even John Makin, a conservative scholar at the American Enterprise Institute, warns that policy-makers ignoring deflation are creating a "necessary, although not sufficient, condition for global depression." That's why we'll see progressives on the committee -- folks like Sens. Sherrod Brown and Jeff Merkley -- pressing Bernanke on what, exactly, he's going to do about the problem.
Bernanke has a few options. One is simply offering advice to Congress -- though Bernanke has yet to acquire, and probably shouldn't, the oracular status of his predecessor, Alan Greenspan, his words are carefully weighed by legislators. Watch for senators from both sides of the aisle to seek his approval for their pet policies, with Republicans asking about the size of the national debt and the deficit and Democrats inquiring about increased fiscal stimulus.
Both will be somewhat disappointed. If Bernanke sticks to his guns, he'll explain that short-term fiscal stimulus is necessary, but his heart is in long-term budget balancing. He isn't likely to endorse a new round of stimulus.
The chairman should be pressed on the Fed's unconventional monetary tools, such as buying public and private debt to lower interest rates further and stimulate growth. The legal authority surrounding this strategy is tricky to manage -- the Fed would likely have to invoke emergency powers. Some Fed officials, like Boston Fed President Eric Rosengren, have advocated actions like this. Regardless, it's clear that Bernanke is not interested in this strategy right now, especially given the difficulties in winding down the Federal Reserve's $2.4 trillion balance sheet, which is bloated from its unprecedented role in fighting the 2008 financial crisis.
If Bernanke offers any substantive shifts, it will be via insights into the Fed's communications policy. While the Fed's famously opaque statements continue to promise low interest rates for an extended period, economic growth might improve if the Fed linked that promise to clear indicators. That way, markets can have a sense that interest rates won't rise until employment is at a specific, healthier level.
Ultimately, while progressives have looked to the Fed as a potential savior from a Senate that refuses to allow majority votes on economic-relief measures, it's becoming clear that the Fed isn't likely to jump into the fray barring an even more serious deterioration in the economy. A recent JPMorgan research note titled "No, Virginia, the Fed is not Santa Claus," underscored the conventional wisdom on the Fed's ability to do more, arguing that even if the Fed undertook a variety of actions, from buying debt to better communications, the benefits would be modest at best.
"For a public that is accustomed to thinking of the Fed as a stern but ultimately benevolent and omnipotent force in the economy, recognizing the limits of monetary policy is a sobering realization," concluded Michael Feroli, JPMorgan's chief economist.
Yet there may be some help on the way to break the gridlock on the Fed's board between those who seek, against all logic, to raise interest rates and the employment-minded directors who are doing their best to hold the status quo. Last week, the Senate Banking Committee finally held confirmation hearings for three new nominees to the Fed's board; all three expressed an interest in seeking a more active monetary policy.
"With unemployment still painfully high, job creation must be a high priority of monetary policy," said Janet Yellen, who if confirmed will be the Fed's vice chair.
Bernanke's challenge today will be convincing Congress, and the public, that the Fed's inaction in the face of deflation and unemployment is somehow justifiable; if he fails, the independence of his beloved central bank will continue to be in question. Much depends on whether Yellen and her fellow nominees, Sarah Bloom Raskin and Peter Diamond, can help Bernanke beat back the hawks and lift up the economy. If the Fed does nothing -- or worse -- raises interest rates too soon, Bernanke's middle course will look like a straight path to economic disaster.
