Wednesday, June 8, 2011

Bernanke, the US economy and monetary policy

Federal Reserve Chairman Ben Bernanke today came as close as is possible in a formal speech by a Fed Chairman to venting frustration. He admitted the economy had recently suffered a “loss of momentum” and was proving to be “uneven” and “frustratingly slow”.

He sees the recent bout of weakness as being largely due to the recent high level of commodity prices that has constrained household budgets and the supply disruptions caused by the Japanese earthquake. He expects both factors to wane and growth to strengthen in the second part of the year. We concur.

The Chairman does not seem overly concerned about the rise in commodity prices and the impact on consumer inflation. He anticipates that over the medium-term they will have a “relatively modest impact”, at least while there is considerable slack in the economy and inflation expectations remain relatively stable.

Understandably he put considerable emphasise on the labour market, noting that “developments in the labour market will be of particular importance in setting the course for household spending”. Yep – can’t disagree with that. He went on to say that “until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established”.

Despite being somewhat frustrated with the pace of the recovery, Bernanke offered no signal that QE3 was in the offing. On the contrary the most telling comment for me in the whole speech was that “monetary policy cannot be a panacea”. Perhaps it’s time for the economy to stand on its own two feet?

We know from the minutes of the April FOMC meeting that the Committee would have to see a significant deterioration in the economic outlook before we saw another round of quantitative easing. Recent weakness in activity indicators, especially if they are largely due to transitory factors, does not meet that test.

However, Bernanke also acknowledges today that the US will soon face “an increasing fiscal drag on the economy” as fiscal policy tightens. That will have significant implications for monetary policy settings as it unfolds.