No amount of liquidity seems to help.
FORTUNE — After six years at the Fed, Ben Bernanke is facing some of the harshest criticism of his chairmanship. Following last week’s meeting of the Federal Open Market Committee, reporters repeatedly pressed him on why he wasn’t doing more to bolster an economy that seems to be faltering just months before a presidential election. The White House has so far shied away from criticizing the Fed, but tensions are rising between the two institutions, as they often do during election campaigns. (Back in 1992, which was also a year of economic worries, many people at 1600 Pennsylvania Avenue believed Alan Greenspan’s inaction cost George H.W. Bush the presidency.)
With media commentators and Democrats pressuring Bernanke to change course, some prominent members of the GOP, Mitt Romney included, are busy warning him against fueling asset bubbles and undermining the value of the dollar. Apparently, they have overlooked the fact that he is a loyal Republican, whom President Bush appointed. Right about now, Bernanke must be wondering why he didn’t stay in his cushy tenured professorship at Princeton. With weak job growth, falling retail sales, and the threat of chaos in Europe, I share the view that Bernanke should be doing more, but I also have some sympathy for him. He is caught in a trap—three of them, actually: a liquidity trap, a communications trap, and a political trap. And only the communications trap is of his own making.
Having in December 2008 reduced the overnight federal funds rate to as close to zero as was practically possible, Bernanke long ago followed the traditional prescription for central bankers operating in a deep recession. Since then, he has gone quite a bit further. In an effort to bring down long-term interest rates, the Fed introduced two rounds of “quantitative easing,” issuing about two trillion dollars and using them to buy bonds. In the past four years, the Fed’s balance sheet has swelled from $800 billion to about $2.8 trillion.
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Just as Keynes warned would happen, Bernanke has found himself pushing on a string. No matter how much liquidity the Fed pumps into the economy, it doesn’t seem to make much difference. With mortgage rates well below 4%, in many parts of the country, the housing market remains depressed. With borrowing costs at record lows, corporations sit on cash and refuse to invest in plant and equipment. In circumstances such as these, an expansionary monetary policy doesn’t necessarily ensure a vigorous recovery. That is why modern Keynesians, of whom Bernanke is one, also favor fiscal stimulus.
Since June of last year, when QE2 came to an end, the Fed has effectively been on hold. (Its ongoing “Operation Twist,” which involves substituting long-term debt for short-term debt in its bond portfolio, is too small to have much impact.) If Bernanke had come right out and said he had run out of ammo and couldn’t do anymore, that would have been one thing. With the Fed officially on the sidelines, the responsibility for bolstering the recovery would have fallen on the administration and Congress. But far from throwing up his hands, Bernanke repeatedly insisted that the Fed wasn’t powerless. He said it again last week: “central banks do have some ability to provide financial accommodation and support a recovery even when interest rates are close to zero.”
In communicating this message, Bernanke has set another trap for himself. If the Fed still has the tools to give the economy a boost, why on earth isn’t it already using them? Its own forecasts show the unemployment rate stuck at close to 8% until at least 2014. The rate of inflation, meanwhile, looks like it is coming in well below the Fed’s 2% target this year and next. For a central bank with a dual mandate of ensuring price stability and ensuring maximum possible employment, these figures can have only one meaning: it’s past time to step on the gas.
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Assuming the June employment report, which comes out July 6, shows another month of lackluster job growth, Bernanke will almost certainly do something. He said as much last week: “If we are not seeing sustained improvement in the labor market, that would require additional action.” Having waited this long, though, the Fed chairman will get caught in the campaign crossfire whatever he does: that is the political trap. If the Fed launches QE3, which in order to make any real difference would have to involve real money—perhaps a trillion dollars—Republicans will accuse Bernanke of pandering to the White House and debasing the currency. If Bernanke continues to sit on his hands, Democrats will be furious at him, and so will many Fed watchers.
At this stage, Bernanke’s best hope of escaping the various traps lies in the next couple of job reports coming in better than expected. This would alleviate fears of another outright slump and dampen calls for immediate policy changes. In that aspect, at least, the interests of the Republican Fed chairman and the Democratic President who appointed him to a second term are perfectly aligned.
