Although output growth should be stronger next year, resource slack and unemployment seem likely to decline only slowly. The prospect of high unemployment for a long period of time remains a central concern of policy. Not only does high unemployment, particularly long-term unemployment, impose heavy costs on the unemployed and their families and on society, but it also poses risks to the sustainability of the recovery itself through its effects on households' incomes and confidence.Bernanke methodically weighed several ideas that have been circulating about how the Fed could give the recovery a push (see e.g., Joseph Gagnon and Alan Blinder).
- Reducing the interest rate on excess reserves (IOER, currently 0.25%) would provide incentive for banks to lend some of the money they are parking at the Fed. Although Bernanke said the availability of bank loans remains a problem for small business, he is not a fan of this option:
[U]nder current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small... Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed's purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.Meanwhile, Senate Republicans have blocked a bill that would funnel more credit to small business through the Treasury.
- Another option would be for the Fed to influence expectations by committing to keeping interest rates low for a given period of time, but this is tricky in practice:
[C]ommitting to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves.Indeed, by putting it that way, methinks the chairman makes it harder to make any such future promises credible.
- Some have suggested raising the (implicit) inflation target (which I have discussed here and here). Bernanke really smacked that one down:
I see no support for this option on the FOMC.... [R]aising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.
- That leaves more "quantitative easing" - creating money and using it to buy assets, which is, according to Bernanke, the "first option":
A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed's earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC's recent decision to stabilize the Federal Reserve's securities holdings should promote financial conditions supportive of recovery.
I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed's balance sheet would have to be weighed against potential risks and costs....
[T]he FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.
Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.
Although many of us think there is no need to wait and see if "further action should prove necessary" (e.g. Mark Thoma) the speech should be somewhat reassuring to those, like Paul Krugman, who argue the Fed is in denial (but he is not reassured).