On July 10, 2013, Ben Bernanke, chairman of the US Federal Reserve, gave his Cambridge, Massachusetts, audience a brilliant tour de force of the evolution of US monetary policy over the past century, including his own views. His intimate knowledge and understanding of the Great Depression and creative use of monetary policy probably explains why this tour de force ended with the "Great Recession" rather than with a second Great Depression. He also indicated that the Fed may be moving away from using the federal funds rate as the single signalling instrument to communicate the objectives and forecasts of its inflation and unemployment targets, thus giving it the constrained discretion to use different instruments at different times. His name will surely go down in history alongside, and arguably above, that of Milton Friedman in the shaping of US monetary policy.
The speech was nevertheless remarkable as much for the range of issues discussed as for what remained unsaid.
First, Mr Bernanke would be the first to admit that he was neither the first to suggest, nor to use, unconventional monetary policies. However, his successful use of the quantitative easing sledgehammer to counter the collapse of the money multiplier proved that his earlier criticism of the Bank of Japan's use of QE in the 1990s as being too timid to beat deflation was spot-on. Indeed, he had started addressing the deflationary threat through aggressive serial rate cuts even as other central banks were still battling inflation. This was a notable policy success during the Great Recession and a notable failure during the Great Depression. Yet QE could not prevent the Great Recession. The correlation between QE and GDP growth remains weak. Mr Bernanke did not discuss the limitations of monetary policy in countering the liquidity trap caused by deleveraging. Advanced economies have had to fall back on long discredited fiscal policy, with even the Fed batting for it to do more of the heavy lifting.
Second, he did not explain why he never felt compelled to use the helicopter drop that he had famously advocated for just such circumstances. A money-financed tax cut would surely not have had the destabilising impact of a bond-financed tax cut, as public debt would not have arisen alarmingly. Or has he already made the drop without us ever noticing? Supposing the Federal Reserve were to hold its treasury bond purchases to maturity, with all payments from the treasury transferred back as profits through book entries, QE would in retrospect be a helicopter drop of money. Any excessive liquidity would then be impounded through recalibration of reserve requirements rather than a roll-back of the balance sheet.
Third, Mr Bernanke underscored the US Fed's adherence to the Bagehot rule: of lending freely in a crisis at a penal interest rate. However, he did not explain whether the rate at which liquidity was made freely available had effectively large penalties or not. The same banks that had endangered the financial system and were bailed out by taxpayers are now making outsize profits despite continuing economic slack. Surely a penal rate would have ensured that some of these profits accrued to taxpayers who are, instead, being penalised in their capacity as savers.
Fourth, just as the Fed (before the Volcker era) was tolerant of high inflation because of the output gap during the Great Inflation, it was tolerant of above-trend output because of low consumer price inflation during the Great Moderation. In either case it was deluded into keeping monetary policy too loose, unleashing stagflation and asset bubbles respectively. Mr Bernanke has however indicated that the Taylor Rule, with its equal focus on inflation and output, will continue to guide US Fed policy despite evidence of the flattening of the Phillips curve on account of deflationary pressures on consumer prices.
Fifth, while drawing attention to financial stability as the original mandate of the Fed, Ben Bernanke was silent on how monetary policy should deal with asset prices. This is particularly relevant for two reasons. First, because excessive liquidity during the Great Moderation was reflected not in consumer but asset-price inflation; and second, because his own easy monetary policy is contributing to new asset bubbles He has of course indicated that this is work in progress. However, he could have clarified whether he still subscribes to the Alan Greenspan doctrine that central banks cannot, and should not, call asset bubbles, and only clean up afterwards. Or whether he is now more open to taking a page out of emerging-market central banks that target financial stability more explicitly through new instruments?
Sixth, Mr Bernanke was silent on the global spillovers of US monetary policy thanks to greater financial integration and the growing dominance of the dollar as the international reserve currency. While monetary policy all over the world responds to the domestic business cycle, the case of the US Fed is singular in that its policies shape cross-border capital flows, thereby influencing the monetary stance of other countries in ways that may be inappropriate for their own business cycles.
In 2007-08, when the Fed turned on the liquidity tap, emerging market economies that recovered relatively quickly from the crisis hesitated to tighten monetary policy for fear of attracting more capital inflows. India's currency appreciated despite a widening current account deficit. Now, when growth is collapsing, EMEs hesitate to loosen monetary policy because, whatever the Fed's real intention, the resultant monetary tightening is drawing capital out of EMEs. The build-up of reserves in EMEs is as much a defensive response to US monetary policy as the pursuit of mercantilist policies by some EMEs.
These are no doubt all difficult and cutting edge issues in the current global debate on monetary policy, with no ready answers. Central bankers are also reticent creatures. But Ben Bernanke is much more than a creative practitioner of his craft. He is one of the foremost academic authorities on unconventional monetary policy in general, and on the Great Depression in particular. His tour de force would have been fascinating had he given us some more insights into his current thinking on these burning issues.
The writer is a civil servant. These views are his own