ECONOMY

Here's What Bernanke Should Do

by Daniel Gross
Friday, October 15, 2010

Federal Reserve Chairman Ben Bernanke, speaking at a conference on Friday morning, says that the high unemployment rate and low inflation signal a need for further easing, but the Fed is still weighing just how aggressive that easing should be. The most likely scenario is that the Fed would purchase hundreds of billions of dollars worth of government bonds.

The ultimate goal is to boost faltering domestic demand for goods and services. In simplistic terms, Bernanke wants to reduce the unemployment rate, get more people shopping at Wal-Mart, and get them to spend more when they do. Consumers have yet to regain lost spending power due to the weak job market and falling home values. Businesses are reluctant to hire and expand when they don't perceive strong demand.

But while there are plenty of good arguments for QE2, there's plenty of reason to believe it may not bring about the desired results. And instead of hearing him talk about what the Federal Reserve can do to get more people shopping at Wal-Mart, I'd rather hear Bernanke talk about what other people can do.

Over the past two years, the Fed has done plenty of old-fashioned easing (lowering overnight interest rates to rock-bottom levels) and new-style quantitative easing (buying $1 trillion in mortgage bonds). Rolling out the heavy firepower has helped lower market interest rates, as this two-year chart of the 10-year U.S. bond shows, but hasn't done a great deal to spur consumer spending and domestic demand.

Market analysts believe the Fed stands ready to spend $500 billion on government bonds. Opinions differ within the Fed on the effects that would have. As Reuters reports, New York Federal Reserve President William Dudley believes that would be the equivalent of reducing short-term interest rates by 50-75 basis points, while Kansas City Federal Reserve President Thomas Hoenig says it would reduce them by only 10-25 basis points. But there's no guarantee that the purchase, alone, will bring the rates down. It's entirely possible market interest rates could drift down further without quantitative easing, as investors seek a safe haven or grow concerned about deflation. And it's entirely possible market interest rates drift higher even as the Fed steps up its purchases.

But assuming rates fall, then what? Mortgage rates may decline further, which will allow more homeowners to refinance mortgages. Refinancing activity has spiked in recent weeks. But lots of people can't refinance because their homes are underwater. When people do refinance, they're more likely to swap to a lower fixed payment rather than do cash-out refinancings. It's not likely mortgage equity withdrawal will come back as a fuel for consumer spending, as it was during the boom years.

Creditworthy companies will get even cheaper access to capital, and junk-rated companies will find they're able to replace high-yielding debt with lower-yielding debt. Microsoft recently issued three-year bonds at less than one percent. But companies are taking advantage of lower interest rates to refinance existing debt, or boost their capacity to pay dividends, or conduct stock buybacks. That's good for shareholders. As The Wall Street Journal reported Thursday, private equity backed companies are using favorable credit markets to issue debt to pay fat dividends to their owners. That may stimulate the economy in St. Barts and the Hamptons -- but not in Toledo.

Of course, companies could deploy capital raised through cheaper debt to invest in new productive capacity or to hire. But given the global macroeconomic climate, in which the U.S. is growing much more slowly than the rest of the world, large companies will be more likely to do so overseas than at home.

So if your goal is to empower consumers to spend more without taking on more debt, or to give small businesses the confidence to hire, spending $500 billion on government bonds may not be the most effective use of your money.

The real issue Bernanke faces is that he may have done as much as he can on his own. Stimulus can stem from monetary policy or fiscal policy. And while the nation awaits more of the former, we seem to have given up on the latter. The stimulus package, passed in early 2009, continues to roll out. But many of its effects have been offset by state and local government austerity measures -- job cuts, tax hikes, fare increases for public transit.

So instead of trying to talk interest rates down, Bernanke might perform a better service if he would begin to urge the political system to do its part. What if he summoned up some uncharacteristic passion, and begged the rest of Washington -- Democrat, Republican, Socialist, libertarian, Congress, White House -- to do something to help him help us? There are plenty of ways to get cash into the hands of people who will spend. A payroll tax holiday, rebates, tax reductions, infrastructure spending, aid to states, make-work jobs. All of the above, or some combination thereof.

Monetary policy alone didn't get us into this mess. And while it may be an extraordinarily powerful lever, monetary policy alone can't get us out