Monetary policy and markets

Financial markets

Buttonwood's notebook

Monetary policy and markets

Ben speaks

by Buttonwood

SO why did markets fall in reaction to Ben Bernanke's speech yesterday? Was it when he said "the economic outlook remains unusually uncertain". Well, duh. One should hope the outlook is uncertain. Why else would the Fed be holding rates close to zero, and punishing savers* round the country?

The more likely explanation is that the markets had heard rumours of some new Fed action to stimulate the economy, such as more quantitative easing, and were disappointed when nothing concrete was announced. Yes, Mr Bernanke said the Fed was not out of bullets and was

prepared to take further policy actions as needed to foster a return to full utilisation of our nation's productive potential in a context of price stability.

My US colleague's analysis is here. But here's a thought. Perhaps that combination of goals isn't possible. The US can get its economy back to previous rates of growth, but only at the cost of higher inflation, or it can keep inflation low at the cost of lost output.

Or perhaps the Fed isn't all powerful. In Japan, they have inflated the money supply, pushed rates down to zero and run huge fiscal deficits without dragging themselves out of a long period of stagnation. One could argue that they acted less quickly than the US but then this was hardly surprising. The bubble is perceived to have burst at the end of the 1980s when the Tokyo stock market peaked. Looking back at the IMF's world economic outlook from 1992, and the growth rates for Japanese real GDP in 1990 and 1991 were 5.2% and 4.5% respectively. What was the problem, the Bank of Japan might well have thought. Supposedly the Japanese banks were slow to admit their bad debt problems but is the US banking sector doing the same thing? Look at this piece from the Wall Street Journal on how "extend and pretend" has been a standard strategy for US real estate loans.

Perhaps a long period of sluggish growth is inevitable after a debt crisis, as the Reinhart/Rogoff work suggests. Maybe the markets are realising that Mr Bernanke doesn't have a magic formula for getting us out of this mess. In this week's column, I look at the dollar/gold link as an indication of confidence in the power of central bankers. The dollar's rise (relative to gold) in the 1980s and 1990s reflected the belief that Paul Volcker had shown how to vanquish inflation; its peak was in 1999, just as Bob Woodward was researching Maestro, his book about Alan Greenspan, and just as senator Phil Gramm was telling Greenspan that

You will go down as the greatest chairman in the history of the Federal Reserve Bank.

Nemesis duly followed in the form of the last dismal decade.

* An economy needs savers. Somebody has to refrain from current consumption so that business has the money to invest in the machinery and processes that will create future production.