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Will Big Ben Get It Right?

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At the US Federal Reserve's recent and first-ever public press conference, Chairman Ben Bernanke gave a spirited defence of the Fed's much-criticised policy of mass purchases of US government bonds, also known as quantitative easing (QE). But was his justification persuasive?

Most economists viewed his performance as masterful. But the fact that the dollar has continued to slide while gold prices have continued to rise suggests considerable scepticism from markets. One of the hardest things in central banking is that investors often hear a very different message from that which the central bank intends to send.

The Fed, of course, has been forced to turn to QE, because its normal tool for fine-tuning inflation and growth, the overnight interest rate, is already zero. Yet US economic growth remains sluggish, and is accompanied by high unemployment. QE has been blamed for everything from asset-price bubbles to food riots to impetigo.

Critics say that QE is the beginning of the end of the global financial system and that too little is known about how it works, and that the Fed is taking undue risks with the global financial system to achieve a modest juicing of the US economy.

One thing is clear: with the Fed lagging other global central banks in the monetary-tightening cycle, and with rating agencies contemplating a downgrade of America's credit score, the dollar's purchasing power has sunk to an all-time low against the currencies of the US's trading partners.

Bernanke's defence was robust and unequivocal. He argued that QE is not nearly as unconventional as its critics claim. If one looks at how it has affected financial conditions, including long-term interest rates, volatility, and stock prices, QE looks an awful lot like conventional interest-rate policy, which we think we understand. Thus, concerns about QE's ill-effects are wildly overblown, and there is nothing especially challenging about eventually reversing course, either. Bernanke dismissed complaints about commodity prices and emerging-market inflation, arguing that these phenomena had far more to do with lax monetary policies and overly rigid exchange rates in fast-growing developing economies.

His comments come at a sensitive time. Over the next year or so, the Fed is likely to enter a tightening cycle, raising interest rates on a steady and sustained basis. It does not want to rush, because the US economy is still weak. But it cannot wait too long, lest inflation expectations drift to a dangerously high level, forcing the Fed to move aggressively — and at the cost of considerable economic pain — to wring inflation out of the system.

In unwinding QE, Bernanke must avoid another landmine — an unwelcome collapse in asset prices. Many savvy Wall Street traders are convinced that QE is just the old Greenspan Put on steroids. The cult of the Greenspan Put stemmed from the previous Fed chairman's avowed belief that the Fed should not try to resist a sharply rising stockmarket, except to the extent that such a market undermines the long-term stability of prices for ordinary goods.

Is QE merely the sequel to the Greenspan Put? It is certainly the case that today's super-low interest rates encourage investors to pour funds into risky assets. The Fed might argue it is the job of regulators to ensure asset bubbles don't induce too much borrowing and an eventual debt crisis, though of course monetary policy has to be in the mix.

Given the sluggish recovery, Bernanke could have gone even further and argued that the Fed is the one who has it right. Other monetary authorities such as the European Central Bank might be over-reacting to short-term inflation volatility. However, Bernanke took a more cautious approach, merely defending the Fed's policy.

Bernanke had to be careful not to say anything that might overly alarm investors. Indeed, there is already reason enough for them to be nervous: after all, the Fed's epic easing of financial conditions must eventually be followed by exceptionally painful tightening. Will the economy be ready when the time comes? Explaining the inevitable shift to tightening could prove a far greater challenge than explaining the exceptional accommodation of quantitative easing.

The Fed must remember that it is dealing with markets that can be anything but rational. Because so much emotion has been invested in QE, the psychological effects of returning to normalcy are going to be perilous and unpredictable.

The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.

Copyright: Project Syndicate, 2011

(This story was published in Businessworld Issue Dated 16-05-2011)