Uneasy Money

The stock market apparently took heart from Chairman Bernanke’s testimony today to the Joint Economic Committee of Congress, rising 4% from its low for the day and 2% from yesterday’s close.  I fear that this is just the market whistling past the graveyard, because Bernanke said very little – actually almost nothing — that he has not said before.  Why the market would have taken any comfort from his remarks is a mystery to me.

What is even more ominous is how closely Bernanke’s testimony tracks the recent message of Jeffrey M. Lacker, President of the Federal Reserve Bank of Richmond whose recent contribution to the second quarter 2011 issue of Region Focus, a publication of the Richmond Federal Reserve Bank, can be found here.

I offer a few of Mr. Lacker’s juicier morsels for your reading pleasure.

Typically following a recession, the economy rebounds strongly, growing more rapidly than the long-run trend for a few years, and then settles back to its more traditional growth path. . . . Occasionally this process has taken a bit longer than one might have expected.  For instance, following the recessions of 1990-1991 and 2001, it was a while before growth exceeded its long-run average of 3 percent. . . . And we may see a similar growth curve this time as well. . . .

[T]here is another possible path the economy might take. . . . We may not see that faster, catch-up level of growth that has followed most recessions.  Instead, we may simply settle into a growth rate of 3 percent.  In short, we may not gain back the ground we lost during the recession.

There are many reasons why this scenario might occur, among them changes in public policuy.  New tax and regulatory policies – including both the recent health care and financial reform bills – could have significant persistent effects on output and consumption.  Moreover, there remains considerable policy uncertainty surrounding such issues – for instance, how fiscal balance will be achieved over the long run.

Nobel Prize winning economist Robert Lucas, among others, has argued that the United States may be headed toward an overall policy regime similar to that of many other developed countries, especially those of continental Europe.  On balance, these countries have more regulated labor markets, higher tax rates, and larger social safety net programs.  While they have roughly the same average rate of growth as the United States, they generally employ less labor and produce less output per capita.  Although these countries are rich by global standards, they typically have been less economically dynamic and are poorer than the United States.

Given that we can’t be sure which recovery path the U.S. economy will take, what should the Federal Reserve do? . . . I think the direction we should take is roughly the same in either case.  Monetary policy is highly accommodative right now.  While inflation trends are currently well-contained at around 2 percent, we need to be alert to the risk that the monetary stimulus now in place might set off an inflationary surge.  [Time out for a comment from the peanut gallery:  Excuse me, but how alert were you (i.e. the FOMC) to the risk of a recession and a financial meltdown in the spring and summer of 2008 when the economy began contracting rapidly while you (the FOMC) were obsessed with preventing inflation expectations from becoming unanchored because of rising oil and food prices?  Does the FOMC have any less obligation to be alert to deflationary surges than to inflationary ones?]  More broadly, it is important that people recognize that, as Chairman Bernanke recently noted, monetary policy is not a panacea.  Monetary policy determines the inflation rate over time, and has only a transitory effect on real economic growth.  Further monetary stimulus is unlikely to alleviate the impediments to more rapid growth, but could raise inflation to undesirably high levels.

The U.S. economy is remarkably resilient.  But . . . we must face the possibility that we  may never fully regain what was lost during the downturn, especially if policymakers do not squarely address those issues that have long loomed over the U.S. economy but can no longer be ignored.

Now for the closing paragraph of Chairman Bernanke’s testimony before the Joint Economic Committee:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies–pertaining to labor markets, housing, trade, taxation, and regulation, for example–also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

Downright scary.