Bernanke’s conundrum: Why do investors trust the Fed?
Former Federal Reserve chief Ben Bernanke said Wednesday he’s puzzled investors seem to have so much faith in the U.S. central bank.
Long-run inflation expectations reflect a belief the Fed will to be able to keep inflation near its 2% target even in the era of low interest rates, Bernanke noted in his latest blog post on the website of the Brookings Institution.
“It will be up to the Fed to prove worthy of that confidence,” he said.
The basic idea is not new. In past good times, the Fed was able to push short-term interest rates up to 5%-6%. This gave the central bank a lot of room to cut rates to combat an economic downturn.
But the recovery from the financial crisis has been different. Since 2008, the Fed is struggling to get short-term interest rates above zero and only lately has them close to 1%. Fed officials don’t expect short-term rates to hit 3% until 2019.
This leaves the Fed with little ammunition to fight the next recession. In other words, hobbled monetary policy means the economy is stuck in a low-rate world. In fact, new research from Fed economists suggests short-term interest rates could be “very close” to zero as much as 40% of the time going forward.
If the Fed cannot provide sufficient stimulus, then inflation should be expected to fall short of the central bank’s 2% target, Bernanke said. Yet market participants expect inflation to stay close to 2% over very long horizons.
“It appears market participants and professional forecasters believe that the Fed, perhaps in conjunction with fiscal policymakers, will ‘do what it takes’ to mitigate the adverse future encounters with the zero-lower-bound,” Bernanke said.
“That confidence is encouraging, but it should not be taken as license for policymakers to rest on their laurels,” he said.
San Francisco Fed President John Williams has said the Fed “really need[s] to think hard about our policy strategy that would be better suited for the zero-bound.”