Bernanke’s Continuing Confusion about How Monetary Policy Works

TravisV recently posted a comment on this blog with a link to his comment on Scott Sumner’s blog flagging two apparently contradictory rationales for the Fed’s quantitative easing policy in chapter 19 of Ben Bernanke’s new book in which he demurely takes credit for saving Western Civilization. Here are the two quotes from Bernanke:

1              Our goal was to bring down longer-term interest rates, such as the rates on thirty-year mortgages and corporate bonds. If we could do that, we might stimulate spending—on housing and business capital investment, for example…..Similarly, when we bought longer-term Treasury securities, such as a note maturing in ten years, the yields on those securities tended to decline.

2              A new era of monetary policy activism had arrived, and our announcement had powerful effects. Between the day before the meeting and the end of the year, the Dow would rise more than 3,000 points—more than 40 percent—to 10,428. Longer-term interest rates fell on our announcement, with the yield on ten-year Treasury securities dropping from about 3 percent to about 2.5 percent in one day, a very large move. Over the summer, longer-term yields would reverse and rise to above 4 percent. We would see that increase as a sign of success. Higher yields suggested that investors were expecting both more growth and higher inflation, consistent with our goal of economic revival. Indeed, after four quarters of contraction, revised data would show that the economy would grow at a 1.3 percent rate in the third quarter and a 3.9 percent rate in the fourth.

Over my four years of blogging — especially the first two – I have written a number of posts pointing out that the Fed’s articulated rationale for its quantitative easing – the one expressed in quote number 1 above: that quantitative easing would reduce long-term interest rates and stimulate the economy by promoting investment – was largely irrelevant, because the magnitude of the effect would be far too small to have any noticeable macroeconomic effect.

In making this argument, Bernanke bought into one of the few propositions shared by both Keynes and the Austrians: that monetary policy is effective by operating on long-term interest rates, and that significant investments by business in plant and equipment are responsive to relatively small changes in long-term rates. Keynes, at any rate, had the good sense to realize that long-term investment in plant and equipment is not very responsive to changes in long-term interest rates – a view he had espoused in his Treatise on Money before emphasizing, in the General Theory, expectations about future prices and profitability as the key factor governing investment. Austrians, however, never gave up their theoretical preoccupation with the idea that the entire structural profile of a modern economy is dominated by small changes in the long-term rate of interest.

So for Bernanke’s theory of how QE would be effective to be internally consistent, he would have had to buy into a hyper-Austrian view of how the economy works, which he obviously doesn’t and never did. Sometimes internal inconsistency can be a sign that being misled by bad theory hasn’t overwhelmed a person’s good judgment. So I say even though he botched the theory, give Bernanke credit for his good judgment. Unfortunately, Bernanke’s confusion made it impossible for him to communicate a coherent story about how monetary policy, undermining, or at least compromising, his ability to build popular support for the policy.

Of course the problem was even deeper than expecting a marginal reduction in long-term interest rates to have any effect on the economy. The Fed’s refusal to budge from its two-percent inflation target, drastically limited the potential stimulus that monetary policy could provide.

I might add that I just noticed that I had already drawn attention to Bernanke’s inconsistent rationale for adopting QE in my paper “The Fisher Effect Under Deflationary Expectations” written before I started this blog, which both Scott Sumner and Paul Krugman plugged after I posted it on SSRN.

Here’s what I said in my paper (p. 18):

If so, the expressed rationale for the Fed’s quantitative easing policy (Bernanke 2010), namely to reduce long term interest rates, thereby stimulating spending on investment and consumption, reflects a misapprehension of the mechanism by which the policy would be most likely to operate, increasing expectations of both inflation and future profitability and, hence, of the cash flows derived from real assets, causing asset values to rise in step with both inflation expectations and real interest rates. Rather than a policy to reduce interest rates, quantitative easing appears to be a policy for increasing interest rates, though only as a consequence of increasing expected future prices and cash flows.

I wrote that almost five years ago, and it still seems pretty much on the mark.


10 Responses to “Bernanke’s Continuing Confusion about How Monetary Policy Works”

  1. 1 TravisV October 15, 2015 at 10:26 am

    Dr. Glasner, thank you very much! I love Sumner but you might be an even better economic historian than he is. And more objective about Milton Friedman, obviously! 🙂


  2. 2 TravisV October 15, 2015 at 10:37 am

    For those who are interested, below is some background on this topic. A key contributor to Bernanke’s misunderstanding was Milton Friedman!


  3. 3 TravisV October 15, 2015 at 10:38 am

    That said, it would be nice if someone wrote something new about the liquidity effect, inflation effect and growth effect and how they tend to drive interest rates in opposite directions…..


  4. 4 RaviVarghese October 15, 2015 at 11:53 am

    David – I see your point that’s it’s odd and hyper-Austrian for Bernanke to credit a fall in rates with stimulating spending. But I’m guessing some people are misunderstanding the nature of the contradiction. I think some people are confusing Bernanke’s desire to raise Treasury yields and to lower corporate yields. By which I mean I assume Bernanke saw QE as raising Treasury yields (getting people out of safe assets), but reducing total yields on risky assets such as corporate bonds by reducing the risk premium, which increased sharply in 2008 (by virtue of Treasury yields going down and corporate yields going up).


  5. 5 Hugo André October 16, 2015 at 2:03 am

    I have one small objection to Glasners reasoning namely his criticism of how Bernankes Fed operated during the crisis. Yes, a change away from the 2% inflation target would have been preferable but the US monetary authorities handled the crisis much better than almost all other central banks in the developed world. There is also the question of what’s politically permissible. It seems to me a plausible possibility that the FOMC would have liked to change the target rule but decided not to because the political opposition (to such a decision) would have been too difficult to handle.


  6. 6 Frank Restly October 16, 2015 at 2:37 am


    “In making this argument, Bernanke bought into one of the few propositions shared by both Keynes and the Austrians: that monetary policy is effective by operating on long-term interest rates, and that significant investments by business in plant and equipment are responsive to relatively small changes in long-term rates.”

    Except that in any lending arrangement, both the borrower and the lender must be accepting of the terms. Yes the central bank can buy existing government bonds and push up bond prices (push down bond yields). That doesn’t mean the central bank can force JP Morgan (or it’s shareholders) to accept a lower interest rate on the loans that it makes for plant and equipment.

    The central bank can affect the spread between the rate that JP Morgan borrows at versus the rate they are willing to lend at. The federal government can affect the after tax cost of a company building a plant or buying equipment.

    But Bernanke seems to be a bit clueless regarding long term investment decisions and the role the central bank plays in those decisions.


  7. 7 David Glasner October 16, 2015 at 11:07 am

    Travis, Scott knows way more about the Great Depression than I do, as his forthcoming book is going to conclusively demonstrate. Scott is just more forgiving than I am when it comes to Friedman.

    Ravi, And I see your point, but I think the larger issue is that focusing on small interest rate changes is misleading, and Bernanke’s public explanations of Fed policy kept the focus on interest rates as the key variable.

    Hugo, Well, I do give Bernanke credit for keeping things from getting much worse than they did, and I understand that there were severe political constraints on the Fed’s freedom of action, so I don’t think that we are disagreeing that much.

    Frank, The theory is that if you push down the riskless interest rate, it will have some effect on other interest rates as well. That’s not necessarily true, as you point out, but it wouldn’t necessarily be wrong to make such an assumption. My point is that even if it’s true, it doesn’t get you very far.


  8. 8 Marcus Nunes October 16, 2015 at 12:43 pm

    David, back when he was deputy and then Treasury Secretary, Summers thought fiscal consolidation would be expansionary because it would lower long term real rates. Obviously, the opposite happened, with real rates rising together with the stockmarket and the overall economy!


  9. 9 TravisV October 16, 2015 at 3:57 pm

    Dr. Glasner,

    You’re a classy guy. However, modesty is overrated. Ask Donald Trump! 🙂


  1. 1 Links 10/16/15 | naked capitalism Trackback on October 16, 2015 at 4:00 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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