Fed has the tools to fight next recession: Bernanke

Washington

FORMER Federal Reserve chairman Ben Bernanke delivered what he called "a relatively upbeat" assessment of the US central bank's ability to fight the next recession.

While the Fed has limited room to cut short-term interest rates because they are already so low, Mr Bernanke argued that quantitative easing and forward guidance could provide enough extra punch to combat a future economic contraction.

"The new policy tools are effective," he said in a blog post summarising his address to the American Economic Association's annual meeting last Saturday. "Quantitative easing (QE) and forward guidance can provide the equivalent of about three additional percentage points of short-term rate cuts."

Mr Bernanke said that the Fed should also consider adopting some of the tools employed by other central banks, including yield curve control out to two years and funding for lending programmes.

He counselled the Fed against ruling out the possibility of pushing short-term interest rates below zero - something which many current policymakers have come very close to doing in their public remarks.

No matter what approach the Fed adopts to fight future recessions, longer-term yields will probably spend extended periods of time at zero or below, according to Mr Bernanke, now a Distinguished Fellow at the Brookings Institution in Washington.

That may pose risks to financial stability. "Monetary easing does work in part by increasing the propensity of investors and lenders to take risks," he said. "Vigilance and appropriate policies, including macro-prudential and regulatory policies, are essential."

His estimate of the impact of QE and forward guidance assumes that the Fed adopts a policy of promising not to raise rates from zero until inflation reaches 2 per cent. While policymakers are considering changes in their approach to achieving their inflation goal, it is not clear they would go as far as that.

Mr Bernanke said his judgment that monetary policy will be able to combat the next recession also rests on a crucial hypothesis: that the neutral level of short-term rates which neither spurs nor restricts economic growth is between 2 per cent and 3 per cent.

If the equilibrium rate is much below that, as some Fed research has suggested, then QE and forward guidance will not be sufficient to fight off a downturn.

"In that case, other measures to increase policy space, including raising the inflation target, might be necessary," he said.

Fiscal policy may also have to play a more central role in countering a contraction - a possibility that the government should be preparing for now, Mr Bernanke said.

Central banks in Europe and Japan face even greater difficulties, largely because inflation expectations there have fallen too far. "In those jurisdictions, fiscal as well as monetary policy may be needed to get inflation expectations up," he said. "If that can be done, then monetary policy, augmented by the new policy tools, should regain much of its potency."

Mr Bernanke said that monetary policy has almost come full circle since the days of the late Fed chairman Paul Volcker.

Now, the problem is not that inflation is too high - it is the risk that it is too low.

"Low inflation can be dangerous," Mr Bernanke wrote in his blog. "Consistent with their declared 'symmetric' inflation targets, the Federal Reserve and other central banks should defend against inflation that is too low as least as vigorously as they resist inflation that is modestly too high." BLOOMBERG