Bernanke Pessimism Drives Credit With Forced Government Cutbacks

Monday, 27 Feb 2012 09:53 AM

 

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Federal Reserve Chairman Ben S. Bernanke is trying to compensate for the damage lawmakers threaten to inflict on the U.S. economy, even as Republicans skewer his stimulus efforts for risking inflation.

The potential drag from fiscal restraint contributed to the rationale behind policy makers’ reduced forecasts for growth this year and in 2013, according to the minutes of their Jan. 24-25 meeting. They also decided to extend their commitment to keep interest rates near zero through at least late 2014 instead of mid-2013 to provide “more accommodative financial conditions,” the minutes said.

Bush-era tax cuts and expanded unemployment benefits are set to expire at the end of the year, and a deficit-reduction law requiring $1 trillion of cutbacks also kicks in if lawmakers can’t agree on a new plan. The Fed may keep rates low for longer because the budget-balancing measures slated for 2013 -- including those automatic cuts, known as sequestration -- threaten to weigh on expansion, said Ward McCarthy, chief financial economist at Jefferies & Co.

They “would certainly take a bite out of growth,” McCarthy, a former senior economist for the Federal Reserve Bank of Richmond, said in a telephone interview from his New York office. “The fact that we have a dysfunctional fiscal policy is a contributing factor to why we have such extraordinarily accommodative monetary policy.”

Bernanke, who is scheduled to deliver his semiannual monetary-policy report to the House Financial Services Committee on Feb. 29, has urged Congress to avoid sudden tightening while encouraging it to adopt a long-term program that balances spending and revenue.

‘Credible, Strong Plan’

“You want to make a credible, strong plan, but one that phases in over a period so that the economy will not hit a huge pothole,” the Fed chairman told the Senate Budget Committee in Washington on Feb. 7. “If no action is taken on Jan. 1, 2013, between expiration of tax cuts, sequestration and a number of other measures, there will be a very sharp change in the fiscal stance of the federal government, which by itself, with no compensating action, would indeed slow the recovery.”

U.S. fiscal policy will subtract 0.75 percentage point from the nation’s economic growth in 2013, up from 0.4 point this year, according to the median response in the Federal Reserve Bank of New York’s survey of primary dealers before the Federal Open Market Committee’s January meeting.

After Congress waged bitter fights over the debt ceiling last year that contributed to Standard & Poor’s August downgrade of the U.S. credit rating, the country again will approach the borrowing limit late this year. Unless Congress acts, defense and other spending will be reduced by $1.2 trillion.

Extending Tax Cuts

Democrats and Republicans voted Feb. 17 to extend a payroll-tax cut through the end of the year. While this is positive, giving lawmakers almost nine months before they must address the next significant budget question, “we’ve got all the things that expire at the end of this year, which is even a potentially greater fiscal drag,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York.

That’s one reason Fed policy makers are “worried about the outlook and why they’re not as enthusiastic” about prospects for the economy, Feroli said.

In January, the Fed lowered its projected range for growth this year to 2.2 percent to 2.7 percent, down from 2.5 percent to 2.9 percent in November. The range for next year now is 2.8 percent to 3.2 percent, down from a previous forecast of 3 percent to 3.5 percent. The U.S. expanded 1.7 percent in 2011.

‘Drag’ on Activity

“A number of factors were seen as likely to restrain the pace of economic expansion, including the slowdown in economic activity abroad, fiscal tightening” in the U.S. and the impact from the sovereign-debt crisis in Europe, according to the minutes from the January meeting. “Many participants judged that U.S. fiscal policy would still be a drag on economic activity in 2013, but many anticipated that progress would be made in resolving the fiscal situation in Europe.”

European finance ministers approved a 130 billion-euro ($174.8 billion) package for Greece on Feb. 21 by tapping into European Central Bank profits and convincing investors to provide more debt relief to the Mediterranean country.

While the move is an “important step,” there are “a number of additional steps that are going to be necessary to put Greece firmly on a sustainable path,” Lael Brainard, the U.S. Treasury Department’s top international official, said in a Feb. 21 interview on the “Charlie Rose” television show.

Worst Political Backlash

Bernanke’s stimulus measures -- which include buying $2.3 trillion of bonds in two rounds of so-called quantitative easing from December 2008 until June 2011 --already have unleashed the worst political backlash against the Fed in three decades. Republicans from House Speaker John Boehner of Ohio to presidential candidate Ron Paul of Texas have warned that the Fed’s measures risked a sharp acceleration in prices.

“I was greatly concerned to hear that the Fed recently announced that it would be willing to accept higher than desired inflation in order to focus on the other side of its dual mandate, which is promoting employment,” Republican Representative Paul Ryan of Wisconsin said at a Feb. 2 hearing before the House Budget Committee, which he chairs. “And I would simply just quote Paul Volcker, who said in the late 1970s, ‘central bankers who are willing to tolerate a little more inflation usually end up getting a whole lot more than they expected.’”

Bernanke said at the hearing he was “very cognizant of Chairman Ryan’s concerns but at least for now, we appear to be pretty close to target,” which he reiterated is a 2 percent rate of price increases.

No Surge Yet

So far, the surge in inflation hasn’t happened. The personal-consumption-expenditures price index rose 2.4 percent for the 12 months ending in December, near the Fed’s goal. Going forward, the level of inflation may depend on the balance between fiscal and monetary stimulus, according to John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina.

If “you’ve got a combination of very easy monetary policy and very easy fiscal policy, that’s probably not a good combination,” Silvia said. “Further fiscal restraint in 2013 and 2014” may warrant monetary accommodation.

Bond traders also aren’t predicting a rapid acceleration in prices. The break-even rate for five-year Treasury Inflation Protected Securities, the yield difference between the inflation-linked debt and comparable maturity Treasuries, was 2.1 percentage points on Feb. 24. The rate, a measure of the outlook for consumer prices over the life of the securities, has fallen from 2.47 points on April 29.

Calls for Fiscal Stimulus

So-called Keynesian economists, including Nobel-prize winner Paul Krugman, lament the impact of government-spending cuts on the economy and are calling for fiscal stimulus. The cutbacks -- in the face of an unemployment rate that’s held above 8 percent since February 2009 -- are “disheartening,” Krugman, a professor at Princeton University in New Jersey, said Feb. 17 on a panel at the Metropolitan Museum of Art in New York. “The job of the government” is “to step in.”

John Maynard Keynes was a British economist who advocated government spending to spur growth during the Great Depression.

The potential impact from trying to balance the budget contributed to the Fed’s January decision to push back expectations for higher rates, Feroli said. The Fed has kept its target for the benchmark rate on overnight loans among banks between 0.25 percent and zero since December 2008.

Offsetting Tightening

There’s going to be a “pretty long period of fiscal tightening, so you should probably be requiring a pretty long period of monetary accommodation to offset that,” he said.

The U.S. government workforce is projected to shrink 13 percent this decade, while payrolls expand in almost every other employer category, according to projections this month by the U.S. Department of Labor. The biggest 10-year decline in federal employment on record will leave the government with 372,000 fewer workers in 2020 than it had in 2010.

“The recovery is here, but it’s fragile,” Silvia said. “If we move forward with significant fiscal restraint in terms of eliminating the Bush tax cuts and cutting defense spending, the economy’s going to remain slow for a while,” and monetary policy is “going to stay easy.”


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