Is Ben Bernanke behind the deflation curve?

At this week’s Humphrey Hawkins hearings, Congress gets its six-monthly chance to press Fed Chairman Ben Bernanke on the future conduct of US monetary policy. It does so at a time when there can longer be any doubt that the US economy is in the throes of its worst economic crisis in the post-war period. It also does so at a time when large swathes of the US financial system are insolvent and when credit markets remain largely frozen.

Against this troubling economic and financial market backdrop, it would seem that Congress should hold Mr. Bernanke’s feet to the fire on two very basic questions. Is the Fed being sufficiently proactive to prevent the US economy from falling into a deflationary trap? And are US policymakers doing enough to prevent the US from repeating Japan’s costly mistakes of the 1990s in addressing the acute problems in the US financial system?

When questioning Mr. Bernanke on the future conduct of monetary policy, Congress might want to reflect on the fact that Mr. Bernanke’s three-year tenure at the helm of the Federal Reserve has been characterized by his eventually-doing the right thing. The only trouble is that he has generally done so with all too long and damaging a delay for the well being of the US economy. For not only was he painfully slow last year to bring interest rates down in response to an ever deepening economic and financial market crisis. He also only resorted to aggressively expanding the Federal Reserve’s balance sheet once it was plain for all too see how dysfunctional the US financial system had become.

Congress should be asking whether the same criticism of tardiness might not now be leveled against Mr. Bernanke as he grapples with the country’s growing deflation risk. For, as a renowned expert of the Great Depression and the Japanese deflation of the 1990s, Mr. Bernanke has been very good at articulating the real and present dangers of a Japanese-style deflation taking hold in the US. Yet, as a central bank practitioner, he has been all too tentative in addressing the country’s deflation risk head-on, which only has to heighten the probability of those risks materializing.

Judging by the Federal Reserve’s latest economic forecast, it would seem reasonable for Congress to suppose that Mr. Bernanke grasps the seriousness of the deflation risk threatening the United States. For, even taking into account the recently announced US$800 billion fiscal stimulus package, the Federal Reserve is now forecasting that US economic output will decline significantly in 2009 before recovering only very gradually thereafter. The Federal Reserve is also now anticipating that unemployment will rise to 8.5 percent and that it will stay at an elevated level for a prolonged period of time.

While Congress should compliment Mr. Bernanke on his candor in presenting a sober economic forecast, it should ask whether that forecast is downplaying the downside risks to the economy posed by the global dimension of the crisis. In that context, Congress might remind Mr. Bernanke that no lesser an authority than Paul Volcker observed last week that output in the major industrialized countries was now declining at a pace that was reminiscent of what occurred during the 1930s. This must raise the question as to whether US monetary policy does not now need to be more forceful especially in view of both the very back-loaded nature of the new Administration’s fiscal stimulus package and the fact that a weak global economy precludes the possibility of the US exporting its way out of its recession.

Past experience informs us that very large gaps in labor and output markets must be expected to exert considerable downward pressure on prices and wages. The Fed itself is now expecting that high unemployment will mean that inflation will stay quite low for a protracted period. Going even further, economists at Goldman Sachs are now expecting that headline consumer prices will fall by close to 1 percent in 2009 and that, excluding food and energy prices, there will be practically no increase in consumer prices in 2010. Meanwhile, in the market, TIPS (the government’s inflation-linked bonds) are now anticipating that consumer prices, excluding food and energy, will decline by almost 1 percent a year over the next five years.

Mr. Bernanke has responded to the growing threat of deflation by tentatively moving in the direction of inflation targeting and by having the FOMC announce a long run inflation forecast of between 1.7 percent and 2.0 percent. In addition, acknowledging that with the federal funds rate at close to zero the Fed has exhausted the use of its short-term interest rate instrument, Mr. Bernanke has also indicated that if need be the Federal Reserve stands ready to resort to further non-conventional monetary policy measures. In that context, he has intimated that the Fed might increase its purchases of mortgage-backed securities and it might start buying long-dated US Treasury bonds.

Congress should ask Mr. Bernanke why with the growing threat of deflation he is stopping short of a formal inflation target. Would not a formal inflation target of around 2 percent signal that the Federal Reserve was firmly committed to preventing deflation from taking hold in the US?

In a similar vein, Congress should be asking what is holding Mr. Bernanke back from already buying US treasuries in general and US inflation-linked bonds in particular. With TIPS’ prices presently implying core-price deflation, might not aggressive purchases of these instruments by the Federal Reserve clearly indicate to the public that the Fed was prepared to put its money where its mouth was on its determination to avoid deflation? And might not such purchases offer positive returns to the taxpayer if the Fed was indeed successful in slaying the deflation dragon?

Although not strictly Mr. Bernanke’s remit, Congress should solicit Mr. Bernanke’s views on how he sees the new Administration’s efforts at recapitalizing the US banking system. In particular, he should be asked whether we are not repeating Japan’s mistakes of the 1990s by pretending that the US banking system does not have a major solvency problem and by persisting with the failed policies of the Troubled Asset Relief Program. He should also be asked whether the successful Swedish model of a good bank/ bad bank approach to the US banking system’s solvency problem does not offer better prospects for alleviating the country’s debilitating credit crunch.

At this week’s Federal Reserve hearings, there is no shortage of questions that Congress could legitimately pose to Mr. Bernanke. However, Congress would do well not to lose sight of the fact that the US is presently in the throes of its worst post-war recession. Nor should Congress lose sight of the very real deflation risks facing the economy that if not properly addressed could very well result in a lost decade for the economy.