Oh, My Gosh! We Now Need "Forward Guidance"!

Poor Ben Bernanke. 

To me, the kindest thing that can be said about him is that he is suffering the fate of those who are in charge of large institutions with little or no practical experience in administering any other organization of consequence.  He just does not seem to understand how to lead such an organization and he does not seem to have the capacity to adapt how he does things so as to achieve a better performance. 

Where one can criticize Mr. Bernanke and the Fed, as I have done in the past, for claiming that solvency problems are just liquidity problems, one can also criticize Mr. Bernanke and the Fed for claiming that their problems with the market are ones of the appropriate information flow and not one of credibility.

Now we are presented with the specter of something called “Forward Guidance.”  To quote Mr. Bernanke, “forward guidance and other forms of communication about policy can be valuable even when the zero lower bound is not relevant (short-term rates are not around zero).  I expect to see increasing use of such tools in the future.” (http://www.federalreserve.gov/newsevents/speech/bernanke20111018a.htm)

Mr. Bernanke came into the position of Chairman of the Board of Governors of the Federal Reserve System promising to provide greater openness and transparency to what the Federal Reserve is doing.  He has been consistently more available to the press and others than any previous Fed Chairman.  His latest effort has been to talk directly with the press after four regularly held meetings of the Federal Reserve Open Market Committee to explain what the Fed is doing.  The first such meeting was less than rousing. 

Yet, apparently, Mr. Bernanke is unsatisfied with the results of this accessibility.  Why else would we need to have something dangled in front of us like this so-called “Forward Guidance.”

Roughly, “Forward Guidance” provides banks and financial markets with an explicit idea of what the Federal Reserve is attempting to achieve in the future in much the way that the August 2011 statement that the Fed would keep short-term interest rates low until mid-2013.

And, there are other forms the “Guidance” could take.  For example, Mr. Bernanke has been an advocate of “inflation targeting” something other central banks in the world have adopted.  For example, the Fed, during the regime of Mr. Bernanke, has had an informal target for inflation of 2 percent.  Under the new effort to keep the public better informed, this policy effort, tying interest rate levels to an inflation target, would be made more formal and explicit.

One could also do the same thing with respect to an unemployment goal. 

When this effort of communication does not work, I wonder what Mr. Bernanke will try next.  His increasing attempts to inform the public about how the Fed will operate given the policy parameters it is watching seems to be constantly falling short of what Mr. Bernanke and the Fed have expected.  Hence, the need to try different things.

In my mind, Mr. Bernanke and the Federal Reserve have followed one basic policy since late 2007.  This policy can be described as throwing as much “stuff” as possible against the wall to see how much of the “stuff” can stick to the wall.

The term “stuff” can apply to many things.  An early example of “stuff” was the Term Auction Credit (TAC), which first showed up on the Fed’s balance sheet on December 26, 2007.  During 2008, the Fed became the banker to the world lending to the European Central Bank and the Swiss National Bank, among others, through swap lines of credit.  The Fed’s line item, Other Federal Reserve Assets, which includes these central bank transactions, rose from about $56 billion on December 26, 2007 to $105 billion on August 27, 2008.  Added to this was the Fed’s assumption of assets from the Bear Stearns transaction, which first showed up on July 2, 2008.  Then in the fall of 2008, the door swung wide open. 

Whereas the earlier efforts did not expand Federal Reserve credit appreciably during most of 2008 (this measure rose from about $874 billion on December 26, 2007 to $884 billion on August 27, 2008 as the Fed reduced other categories of assets to expand credit where it seemed to be needed) by December 31, 2008, Federal Reserve credit reached $2.250 trillion!

On October 12, 2011, Federal Reserve credit stands at almost $2.845 trillion!

We have had QE1, and QE2, and now we have “Operation Twist.”  Excess reserves in the commercial banking system have risen from less than $2.0 billion in December 2007 to about $770 billion in December 2008 to over $1.550 trillion in September 2011.

Bank lending remains anemic, at best, and economic growth stays modest. 

What is the Fed’s monetary policy?  The Fed’s monetary policy is to flood the banking system with “cash”.  What else needs to be explained? 

“Operation Twist” and “Forward Guidance” and “QE2” and whatever do not change the general thrust of the Fed’s monetary policy.  The Fed is throwing as much “stuff” against the wall as it possibly can.  And, it will continue to do so for as long as Mr. Bernanke and the Fed feel that it is necessary.

But, Mr. Bernanke does not feel that this is enough.  And, so he tries this and tries that to increase the “openness and transparency” of the Fed to the rest of the world.  I believe that he is concerned about this more to calm his own mind than to calm the mind of the banking system and the financial markets.

The problem is that people are attempting to reduce their debt loads.  The fifty years or so of credit inflation released on American families and businesses by the United States government since the early 1960s has resulted in a situation where these same families and businesses feel that they are burdened by too much debt.  Consequently, they are attempting to reduce their debt loads. (See my post, “The US economy will continue to grow”: http://seekingalpha.com/article/300450-the-u-s-economy-will-continue-to-grow.)

However, de-leveraging takes time.  Unfortunately, given the current circumstances, the only thing that would stop the de-leveraging is a rapid build-up of inflation making debt “economically valuable” again.  In one sense, this is what it looks as if Mr. Bernanke and the Fed are trying to do.

But, with modest economic growth and tepid inflation, families and small- and medium-sized businesses will continue to reduce the amount of debt on their balance sheets.  These people will not come back into the debt market for some time.  This is  consistent with the research published by Reinhart and Rogoff in their book, “This Time is Different.” 

Even if this is true, Mr. Bernanke and the Fed, for the history books, do not want to look as if they did not do everything in their power to combat a second Great Recession…a double dip, if you will.  Consequently, they will stand ready to throw as much “stuff” as they feel they need to against the wall and will continue, in an open and transparent way, to tell the world that they are doing everything within their power to get the economy moving again.  To me, this is a lack of confidence that does not enhance their credibility.

The Current State of Monetary Policy

At the top of my Financial Times this morning reads the blurb: “Did Ben Bernanke Drop the Ball Over QE3?”  This is reference to an editorial by Clive Cook. (http://www.ft.com/intl/cms/s/0/7f55246e-cf2d-11e0-b6d4-00144feabdc0.html#axzz1WPnzI9CU)

In examining the speech given by Fed Chairman Bernanke, Cook takes on the Financial Times essays published last week by Michael Woodford (http://www.ft.com/intl/cms/s/0/aa41c0f2-ce78-11e0-b755-00144feabdc0.html#axzz1WPnzI9CU) and Mohamed El-Erian (http://www.ft.com/intl/cms/s/0/0472f1ea-cd89-11e0-b267-00144feabdc0.html#axzz1WPnzI9CU) that argued against the Fed implementing a QE3.  Cook contends that Bernanke missed a chance…a “chance to jolt ailing America.”

I don’t believe that Bernanke dropped the ball.  I don’t believe that a declared QE3 is necessary.  Whereas Cook believes that a QE3 would “shock” America, I believe that a QE3 would be taken as ho-hum, more of the same. 

In this, I don’t believe that QE1 and QE2 were understood. 

Michael Woodford, the “good” academic states in his essay: “The economic theory behind QE has always been flimsy.”

Get real…this is the “real world”!

QE1 and QE2 were not a result of economic theory.  QE1 and QE2, in my mind, were a response of real people to a desperate real world situation.  In the first case, the financial markets were falling apart.  In the second case, the economy was not growing. 

In both cases, the response of Mr. Bernanke and the Fed’s policy makers were to throw whatever they had against the wall to see what would stick.  There is little in the way of theory behind this.   Some of us believe that in the first case this was not one of Mr. Bernanke’s finest hours. (See my post, “The Bailout Plan: Did Bernanke Panic,” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

In my mind, what was behind these actions was not theory…but history. And, Mr. Bernanke is one of the premier students of the history of the Great Depression and the 1930. 

So, what was behind QE1 and QE2?

In the case of QE1, Mr. Bernanke was aware of the massive monetary history written by Milton Freidman and Anna Schwartz.  The famous conclusion drawn from the Friedman/Schwartz history is that the Federal Reserve allowed the money stock of the United States to decline by one third over the 1929-1933 period. 

Mr. Bernanke and the modern Fed was not going to allow this to take place.  As a consequence, they, Bernanke and the Fed, threw everything they had at the wall.  There was no theory in this.  They were just human beings re-acting in a situation in which there was extreme uncertainty and in which things seemed to be falling apart around them. 

In terms of QE2 we can also go back into the history of the 1930s to get some instruction that might help us understand what the Federal Reserve has been attempting to do over the past year.  The specific case here comes from the period 1937-1938.  The United States economy had been modestly recovering since 1933 but bank lending had not really picked up.  Excess reserves at commercial banks became, for the time under review, excessive.  Since the Federal Reserve’s policy makers did not want to have all these excess reserves around because they felt this reduced their control over the banking system they raised reserve requirements so as to get rid of these “superfluous” reserves.

The consequence? 

There was another collapse of the money stock because the commercial banks “wanted” those excess reserves due to the uncertain times and the slow pickup in business activity.  So, when the Fed took away the excess reserves, the banks reduced their lending activity even more to recover their “excess” reserves and the financial system declined once again.  There was another depression following up on the “Great” one!

Mr. Bernanke, the historian, and the Fed did not and does not want a repeat of the 1937-38 depression.  As a consequence, QE2 was created.  The thought behind QE2 was to throw enough against the wall so that something would stick!  Economic growth was sluggish at best; bank lending was still declining in the summer of 2010; debt loads of businesses, and families, and governments were huge; foreclosures and bankruptcies were at record levels; and under-employment were at levels reached only in the 1930s.  Banks had excess reserves, yet, nothing much seemed to be moving.

Mr. Bernanke and the Fed wanted to escape a replay of 1937-38!

There was little or no theory behind QE1 and QE2.  These two programs were put into place by real people facing extreme situations who did not want to err on the side of not doing enough.  They were people that would let history decide whether or not they acted correctly…and let the theorists debate all they wanted to in their own little worlds. 

And, what are we left with right now?

A commercial banking system that has around $1.6 trillion in excess reserves and about $2.0 trillion in cash assets on its balance sheets.  And, we are told that the central bank is poised to act in the future in anyway needed to shore up the banking system and the economy.  Furthermore, we are told that short-term interest rates are to stay around where they are for two more years. 

Mr. Bernanke, who has overseen both QE1 and QE2, is not afraid to throw more “stuff” against the wall if needed.  This, to me, is current state of monetary policy at the present time.