Economics
By Avery Shenfeld

It’s increasingly evident that America’s economic  recovery is simply not good enough. Not good enough to vanquish unemployment, power consumption, withstand fiscal tightening, and protect against deflation risks down the road. Canadians have a stake in that game, since growth here will slow if the US import engine sputters. Something must be done, and in the week ahead, it’s Ben Bernanke’s FOMC that will be looking at what role it can play in that effort.

What bullets are still left in Bernanke’s arsenal? One suggestion, reducing the rate paid on deposits of excess reserves held at the Fed, would have a trivial impact, since the yield is already so low relative to, say, the yield on a car loan. The very slight movement in that spread is therefore unlikely to trigger a big wave of fresh credit flows.

Quantitative easing, printing even more money to buy securities, rather than winding down the Fed’s balance sheet, can help defuse deflation expectations if done with sufficient aggression. Expectations of higher prices, perhaps abetted by announcing a formal CPI target, can get consumers to buy now rather than later, making savings less attractive. The impact on bond yields is  actually ambiguous. Real rates (the key to economic activity) should fall as the Fed buys securities, but nominal Treasury rates could ultimately move higher if QE is successful in convincing markets that inflation is going to heat up. That said, the impact on the economy from QE will still be dulled to the extent that the money multiplier remains low, and the extra liquidity fails to spark a surge in lending and broader money aggregates.

If the US economy is in such a liquidity trap, two even more aggressive options remain. The Fed can agree to monetize an addition to Treasury debt that is used to finance another significant round of spending or tax cuts. A tax cut financed by printed money is equivalent to the “helicopter drop” of money that Bernanke spoke about in a speech on anti-deflation weapons a decade ago. Or it could print money to buy foreign currency, driving the dollar down in the process. That would boost US export prospects and at the same time reinforce expectations that inflation will stay positive, although it would draw the ire of America’s trading partners who, at this point in the cycle, won’t be happy seeing their currencies appreciate.

But before any of this is even considered, the Fed has  to come to a consensus that laissez faire won’t work. That will require a sea change in thinking. The likes of Hoenig and Fisher are more focused on unwinding stimulus than adding to it, and even Bernanke’s recent testimony spent much more time on the former.  Since the last two recoveries also started with a year or so of job losses, the FOMC could cling to hopes that a jobs revival is just ‘round the corner.

New appointees at the table in September might tilt the balance towards the doves, but couple more quarters of sluggish jobs figures would be even more likely to do the trick. By early 2011, either fiscal tightening will be pushed off, or the Fed will be reaching for unconventional tools to get the economy moving again.

Summary:
Ben Bernanke is the current Chairman of the U.S. Federal Reserve. He was chairman of President George W. Bush’s Council of Economic Advisers. He taught at Stanford’s University School of Business from 1979 to 1985, before being a professor at Princeton University in the Department of Economics. He graduated from Harvard University with a Bachelor in Economics in 1975, and then received a Ph.D. from MIT in 1979.