Bernake's Dilemma

8/21/2019 Bernake's Dilemma

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UVA-GEM-0111Rev. Jul. 29, 2013

This case was prepared by Frank Warnock, Paul M. Hammaker Professor of Business Administration. It was writtenas a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation.

Copyright 2013 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved.To order copies, send an e-mail to [email protected]. No part of this publication may bereproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School

Foundation.

BERNANKES DILEMMA

[N]o central bank anywhere on the planethas the experience of successfullynavigating a return home from the place in which we now find ourselves. No central banknot,at least, the Federal Reservehas ever been on this cruise before.1

Ben Bernanke was entering the final year of a difficult eight-year term as chairman of theBoard of Governors of the U.S. Federal Reserve (the Fed). Earlier in his career, as an economicsprofessor at Princeton, he had written influential research papers advocating a policy of inflationtargeting. Inflation targeting, in its simplest form, is rather mechanical. If inflation is forecasted

to be above some predetermined range, tighten monetary policy; if inflation is projected to belower than the stated range, loosen it. The Feds dual mandate seemed to preclude a pureinflation targetthe mandate dictated that it also focus on employmentbut the thinking whenhe took over in early 2006 was that perhaps the Bernanke Fed would be a de facto inflationtargeter. Alas, at this point, in July 2013, a relatively mechanical inflation targeting policy wasonly a dream.

Bernanke would go down in history as the chairman who brought the Fed into unchartedwaters (for it, at least). His initial response to the global financial crisis (GFC) was to lower thefederal funds (fed funds) rate to about 0% and implement an almost unfathomable campaign ofnew facilities to free up frozen credit markets.2 In November 2008, when the economy was still

very weak and financial markets were reeling, the Fed began its attempt to directly influencelong-term interest rates by making massive purchases of U.S. Treasury bonds, the first of the so-called quantative easing (QE) measures. Those policies raised eyebrows but were largely seen asnecessary to keep the U.S. (and world) economy from sliding into another Great Depression.

1 Richard W. Fisher, Comments to the Harvard Club of New York City on Monetary Policy (With Referenceto Tommy Tune, Nicole Parent, the FOMC, Velcro, Drunken Sailors and Congress), September 19, 2012http://www.dallasfed.org/news/speeches/fisher/2012/fs120919.cfm (accessed February 11, 2013).

2 The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserveto other depository institutions overnight. For a discussion of the many nonstandard credit-easing policies institutedby the Bernanke Fed, see Frank Warnock, Geithner and Bernanke Amid the Global Financial Crisis, UVA-BP-0540 (Charlottesville, VA: Darden Business Publishing, 2009).

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The Bernanke Fed continued with a second round of QE in November 2010, when theeconomy had improved somewhat but inflation was still quite low. Still more measures followed:Operation Twist in 2011; QE3 in September 2012; and QE in December 2012, when it

announced that, so long as inflation and inflation expectations remained contained, it was likelyto keep the QE policies in place until the U.S. unemployment rate fell to 6.5%, a level not seensince the fall of 2008.

The impact of these policies on the Feds balance sheet was striking. In August 2008, theFeds entire balance sheet totaled $895 billion. By May 2013, the Fed owned more than that inmortgage-backed securities alone ($1.1 trillion), as well as $1.85 trillion in Treasury bonds andnotes. Indeed, in early May 2013, the Feds balance sheet exceed $3 trillion.3

Some were less than enamored with the Bernanke Feds policies. Prior to theannouncement of QE3, Campbell Harvey, a leading finance professor, summarized results from

a survey of CFOs as follows:

This is stark evidence that QE3 would be a wasted effortThe CFOs are sayingthat it is nave for the Fed to think that dropping interest rates will spur investmentin current economic conditionsThe surveys bottom line is that the Fed has runout of bullets. The best thing they can do is to foster stability. 4

Some members of Congress thought so little of Bernankes policies that they introducedbills that, if enacted, would greatly change the nature of the Fed. The Sound Dollar Act (H.R.4180), introduced in the House by Joint Economic Committee Vice Chairman Kevin Brady,would change the Feds dual mandate of price stability and full employment to a more focusedmandate on price stability. A more radical act (H.R. 1098) introduced by Ron Paul would goeven further by repealing the legal tender laws, ending the Feds monopoly on money creationand allowing the private production and use of gold and silver as money. Bradys bill would alsogive regional Federal Reserve Bank presidents greater clout in monetary policy decisions.

How would regional Fed presidents use that increased clout? Jeffrey Lacker, president ofthe Richmond Fed, who felt that current Fed policies might be harming the economy and should

3 The current size and composition of the Feds balance sheet is readily available athttp://www.federalreserve.gov/releases/h41/Current/ (accessed May 15, 2013). Data for any week back to June 1996are also available from that site.

4 CFOs: Hiring and Spending Plans Weaken, Fed Policy Viewed as Ineffective Duke University Office ofNews & Communications, news release, September 11, 2012, http://www.cfosurvey.org/12q4/PressRelease.pdf(accessed February 11, 2013).


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be scaled back, dissented frequently in FOMC5 meetings. And he felt that the Feds foray intomortgage-backed securities was wholly inappropriate:

I strongly opposed purchasing additional agency mortgage-backed securities.These purchases are intended to reduce borrowing rates for conforming homemortgages. Such purchases, as compared to purchases of an equivalent amount ofU.S. Treasury securities, distort investment allocations and raise interest rates forother borrowers. Channeling the flow of credit to particular economic sectors isan inappropriate role for the Federal Reserve. As stated in the Joint Statement ofthe Department of Treasury and the Federal Reserve on March 23, 2009,Government decisions to influence the allocation of credit are the province of thefiscal authorities.6

Other regional Fed presidents, such as Eric Rosengren of the Boston Fed, wanted the Fed

to do more to support the struggling U.S. economy:

Mr. Rosengren likened the economy to a swimmer treading water and gettingnowhere. That calls for a more substantive action than weve taken to date, hesaid. We need a pro-growth monetary policy. Treading water, he added, wasnot sufficient. Mr. Rosengren said the Fed should buy more mortgage-backedsecurities and possibly U.S. Treasury securities in an open-ended program, andstated that it will continue to buy bonds until we start seeing some prettysignificant improvements in growth and income.7

The Fed did just that a few weeks after Rosengrens comments when it announced QE3,the very policy that Richmond Fed President Lacker decried. Yet another FOMC member, FedGovernor Jeremy Stein, openly worried that the Feds policy of keeping interest rates persistentlylow might be causing a bubble in the junk bond market. Were the Fed to believe that such abubble would have systemic implications, Stein suggested that preemptive monetary policymight be appropriate.8 Just weeks earlier, Bernanke himself worried about the unintended

5 The FOMC is the Federal Open Market Committee, the Fed committee that makes monetary policy. There areeight permanent positions on the FOMCthe seven Washington-based board members (political appointees with14-year terms) plus the president of the Federal Reserve Bank of New York. While all regional Fed presidents (whoare not political appointees) participate in the process of making monetary policy, only four (in addition to the NYFed president) sit on the FOMC at any one time; that is, in addition to the permanent slots for the seven boardmembers and the NY Fed president, the other four FOMC slots rotate among the other eight presidents of regional

Feds.6 Richmond Fed President Lacker Comments on FOMC Dissent, Federal Reserve Bank of Richmond pressrelease, September 15, 2012.

7 John Hilsenrath, Fed Official Calls for Bond Buying, Wall Street Journal, August 7, 2012.8 Jeremy C. Stein, Overheating in Credit Markets: Origins, Measurement, and Policy Responses, speech at the

Federal Reserve Bank of St. Louiss Restoring Household Financial Stability after the Great Recession: WhyHousehold Balance Sheets Matter, research symposium February 7, 2013,http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm (accessed February 15, 2013).


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consequences of asset purchases: asset purchases are a less well-understood toolwell belearning over time about how efficacious they are, about what costs they may carry with them interms of unintended consequences Bernanke also noted that if the [Feds] balance sheet gets

indefinitely largethere would be potential risks in terms of financial stability, in terms ofmarket functioning.9

Thus, in summer 2013, some members of the FOMC were publicly calling for moreexpansionary Fed policy, while others were calling for an end to the expansionary Fed policy.OthersBernanke includedworried aloud that Fed policy might be creating bubbles and risksto financial stability. To complicate matters, the U.S. economy was in the midst of yet anothersoft spoteconomic activity barely grew at all in the fourth quarter of 2012, and current year-over-year growth was only 1.8%and at least one measure of inflation expectations had justcome off its highest levels in at least a decade (Figure 1).

Figure 1. A measure of inflation expectations.

Bernanke wished for a normalization of U.S. monetary policy, even with a weakenedeconomy and the clear danger of other potential risks. He knew that short rates were too low fortoo long and that some upward movement in short rates would, all else equal, be desirable. Healso yearned for the day when the Fed, rather than being one of the largest holders of U.S.Treasury bonds, once again had a boring, inconsequential Treasury portfolio. And, if he wereallowed to dream, it would be nice not to be engaged in directing credit to the housing sector.

9 See Transcript of Chairman Bernankes Press Conference, December 12, 2012,http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20121212.pdf (accessed February 15, 2013).

Calculated 5-Year Forward Inflation Rate

%

1312111009080706050403Source: Federal Reserve Board/Haver Analytics

3.0

2.5

2.0

1.5

1.0

0.5

3.0

2.5

2.0

1.5

1.0

0.5


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One major step in normalizing U.S. monetary policy would be to substantially reduce theFeds holdings of U.S. Treasury bonds. Before doing so, Bernanke wanted to make sure he fullyunderstood the factors affecting the current and prospective levels of U.S. long-term interest

rates. He knew that to understand the present required knowledge of the past, so he began byrevisiting the Greenspan years.

The Greenspan Era

It was seemingly easy to be the chairman of the Federal Reserve from the mid-1980sthrough 2003 or so. Paul Volcker had done much of the heavy lifting on slaying inflation in theearly 1980s, starting U.S. long-term interest rates on a beneficial downward march. In the 1990s,as long-term rates continued their secular decline, the United States experienced a surge inproductivity growth, real GDP growth was impressively robust for such a mature economy,

unemployment was low, and the federal budget actually went into surplus for a few years. Yes,recessions still occurred, but they appeared to be less frequent and less severe than in pastdecades. (See Exhibit 1 for basic economic indicators.)

During the Greenspan Fed (August 1987January 2006), long-term rates had fallensteadily, although in a controlled manner (Exhibit 2). To be sure, that could be seen as acontinuation of the outcomes engineered by Greenspans predecessor. Under Volcker, long-termrates, which had peaked at more than 15% in 1981, fell to less than 10%. Under Greenspan, rateswere fairly steady (in the 8% to 9% range) for a few years before heading south. Long ratesincreased on occasionmost notably when Greenspan pushed through a tightening of monetarypolicybut the longer-term trend was clearly toward lower rates, and in the final Greenspanyears, long-term interest rates had fallen to historically low levels of 4% to 5%.

One way for long-term interest rates to decline is for longer-term inflation expectations tofall. And fall they did: Long-term inflation expectations, at 4.5% when Greenspan took office,began to decline almost from the day he was sworn in, although they remained at a remarkablystable 2.5% since mid-1998 (Exhibit 3). That unprecedented anchoring of long-term inflationexpectations would be seen by some as Greenspans crowning achievement. William Poole,then-president of the Federal Reserve Bank of St. Louis, said that market confidence in theFederal Reserves ability and willingness to maintain a low-trend rate of inflation has been a corecharacteristic of the Greenspan regime.10 Shorter-term inflation expectations were more volatile,possibly because of the occasional sharp movements in the price of oil. But those, too, appearedto be well contained and, by the end of 2005, had, roughly speaking, been at or below 2.5% foralmost a decade.

10 William Poole, Presidents Message, Federal Reserve Bank of St. Louis Review 87, no. 74 (July/August2005): 42728.


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Perhaps because of the job Greenspanand Volcker before himhad done wrenchinginflation out of the economy, the volatility of interest rates dropped precipitously and thenremained remarkably constant throughout Greenspans reign as chairman (Exhibit 4). With more

muted fluctuations in interest rates, investors demanded less of a premium for protection againstprice and reinvestment risk, another factor reducing long-term rates. The reduced volatility wasdue in part to luckfor example, the U.S. economy had not been buffeted by adverse supplyshocksbut the credibility of the Greenspan Fed also enabled rates to be so stable.

Part of the Feds credibility stemmed from strong performance on the monetary policyfront, but another important component was the increased communication between the Fed andthe market. When Greenspan took over, market participants had to guess at what Fed policy Fed watchers had to divine whether monetarypolicy was being tightened or loosenedthat is, what the target federal funds rate actually wasby observing the type and size of the open-market operations that the New York Feds trading

desk conducted. As William Poole said:

Before 1987, Fed decisions were not only murky to the market but at times evenmurky within the system, including within the FOMCMoreover, beforeGreenspan many within the Fed believed that policy effectiveness depended ontaking markets by surprise.

In February 1994, the Fed began announcing the target federal funds rate, so the publicno longer needed to guess. And at about that time, a new form of policy had taken holdopenmouth operationsin which Greenspan or another Fed official would hint at policy changesbefore they occurred. Through open-mouth operationsand other important steps towardincreased transparencypolicy shocks were taken out of investors thought processes.11

The strong performance on the inflation front and the concomitant general decrease inlong-term interest rates did not occur because of a secular decline in growth prospects in the U.S.economy. Indeed, by the end of the Greenspan Fed, expectations of real economic growthnotwithstanding a sharp hit in late 2001had been steady to increasing for an entire decade(Exhibit 5).

Although the U.S. economys performance during the Greenspan era was widely hailedas impressive, there were some notable problem areas. Onea lax regulatory environmentwasdamning but will not be discussed here. Another problem area was the twin deficits. Greenspanhad credited Robert Rubin and the Clinton administration with lowering the budget deficitevendriving it into surplusso convincingly that nearly everyone foresaw eternal surpluses! Theirefforts had truly made Greenspans work easier. Greenspan, too, believed that long-lived

11 For a clear discussion of increased Fed communication, see Donald L. Kohn, Central Bank Communication(remarks, annual meeting of the American Economic Association, Philadelphia, January 9, 2005),http://www.federalreserve.gov/boarddocs/speeches/2005/20050109/default.htm (accessed June 27, 2011).


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surpluses were a distinct possibility. Knowing Washington as he did, he knew the tides couldturn quickly, but as late as mid-2001, hisand his staffsbest guess was that while themagnitudes of future federal unified budget surpluses are uncertain, they are highly likely to

remain sizable for some time.

12

But the 1990s budget surpluses quickly evaporated and turned into large, prolongeddeficits (Exhibits 1 and 6). To be sure, the events of September 11 put pressure on the budget.But Greenspan also had to accept some of the blame for the shift to large deficits because whenthe federal funds rate was approaching zero, he had opined that a stimulative tax cut wouldnt beharmful. What he really wanted was for economic growth to pick up enough to get short-termnominal rates away from zerohow would the Fed conduct monetary policy if short rates fell tozero? What he failed to count on (but, in retrospect, should have counted on) was that once thetax cut/high-spending genie got out of the bottle, there was no putting it back. On the federalbudget, it took the Bush administration less than three years to completely erase the work the

Clinton administration had done over the previous eight.

The current account deficit (Exhibit 7)as it approached a troublingly large 5% of GDPin 2003 (and would exceed 6% by 2005)brought less consternation but did concern theGreenspan Fed. Foreigners seemed willing to finance the huge deficit: foreign flows into U.S.securities exceeded the current account deficit most years. (Greenspan often wondered if thelarge deficits prompted the inflows or if the large inflows produced the deficits.) If the hugeinflows were financing investment, he would be less worriedthere was nothing wrong withborrowing today to expand productive capacity tomorrowbut they appeared to coincide withsurges in consumption and fiscal deficits.13 There was also concern that the huge current accountdeficits were being financed by bond flows (rather than flows into equities or foreign directinvestment); Greenspan was not overly concerned with that fact because he, like almosteveryone, believed the U.S. financial system could adequately intermediate funds. Little did he(or Bernanke) know that this basic belief in the efficacy of the U.S. financial system was, as itturned out, sorely mistaken.

12 See Alan Greenspan, The Paydown of Federal Debt (remarks, Bond Market Association, White SulphurSprings, WV, April 27, 2001), http://www.federalreserve.gov/boarddocs/speeches/2001/20010427/default.htm(accessed June 27, 2011).

13 For an analysis of the preconditions that, on average, lead to a more painful unwinding of a large currentaccount deficit, see Caroline Freund and Frank Warnock, Current Account Deficits in Industrial Countries: TheBigger They Are, the Harder They Fall?, in G7 Current Account Imbalances: Sustainability and Adjustment, ed.Richard H. Clarida (Chicago: University of Chicago Press, 2007), 13362.


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The Bernanke Years

The conundrum

Bernankes time at the Fed began in 2003 while Greenspan was still chairman. As a newgovernor at the Fed, Bernanke saw Greenspan keep the federal funds rate at the abnormally lowlevel of 1% for over a year. That seemed to surprise many Fed watchers, but the reason was verysimple: after more than a decade of fighting inflation, Greenspan actually wanted a bit moreinflation. That apparent paradox derived from one very basic fact. Although the Fed technicallyhad a variety of possible instruments with which to conduct monetary policyand had useddifferent instruments in the pastthe federal funds rate had become the instrument of choice forthe Greenspan Fed. With the fed funds rate at 1%, there just wasnt much room to lower itfurther in the event that the economy needed a stimulative push. Strong growth and a bit moreinflation would naturally put upward pressure on short rates and allow the fed funds rates to

move away from zero.

By early 2004, when it was clear that growth was strong and sustainable, Greenspan usedopen-mouth operations to signal that the Fed was about to engage in a tightening phase. Becausethis was well telegraphed and was presumed to be ongoing for a year or more, many (includingGreenspan and Bernanke) assumed that long rates would move up sharply from their historiclows. As it happened, the Fed raised the fed funds rate slowly but surely to 3.25% by mid-2005.That tightening, especially in the context of surging oil prices, would usually result in higherlong rates. But long rates remained stubbornly low, prompting Greenspan and Bernanke toponder this new conundrum.

A possible driver of the conundrum, put forward by then-Governor Bernanke, was thatthe world was awash in savings that exceeded desired investment.14 This global saving glutwas eminently plausible but hard to verify quantitatively. There was a source of dataglobalcapital flows datathat could possibly speak to an aspect of the global saving glut, but at thetime, it was not clear how to interpret the capital flows data. Greenspans capital flows experthad been keeping him abreast of the very large positions foreign governments were taking inU.S. government bonds (Exhibit 8). Greenspans interest in these data began with the AsianFinancial Crisis, and he kept an eye on these so-called official flows more as a timely way oftracking which emerging economies were doing well (and building up foreign reserves) andwhich were drawing down reserves. But during the last few years of the Greenspan Fed, itseemed that many countries were adding to their foreign reserves, and in aggregate, these foreignofficial positions had become huge; by 2004, foreigners (including private foreign investors) hadacquired more than half of all outstanding Treasury securities. If foreign governments held onlyshort-term U.S. debt instruments, the impact on U.S. rates would be minimalthe markets at the

14 Ben Bernanke, The Global Saving Glut and the U.S. Current Account Deficit (Homer Jones Lecture, St.Louis, MO, April 14, 2005), http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm(accessed June 27, 2011).


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short end of the yield curve were so deep and so closely tied to monetary policy instruments thatit was hard to imagine that foreign flows could materially affect prices. But there was evidencethat some foreign governments were moving out the yield curve into some of the longer-dated

maturities.

At a July 2005 briefing, Senator Richard Shelby asked Greenspan if those foreign flowscould affect long-term U.S. interest rates:

This committee has previously raised questions with you, Mr. Chairman,regarding the large Chinese and Japanese official holdings of U.S. Treasuries.Your report today indicates that data from Treasury indicates that demand forthese securities from foreign official investors has ebbed during the first fivemonths of this year. Obviously, the Chinese government announcement to switchto a currency basket in setting its peg could also affect that demand. Mr.

Chairman, do you anticipate that long-term rates may be affected by the changesin foreign official demand, or do you expect such changes to unfold slowly overtime and thus be absorbed into the market?15

In Greenspans response to the senator, he noted that foreign accumulation probablylowered long-term U.S. interest rates by fewer than 50 basis points, and so the unwinding ofthose positions, were it to occur, would only add a small amount to long rates. But he knew thatthe estimates he had in his back pocket included only those bonds held at the New York Fed onbehalf of foreign governments. Because some governments avoided the New York Fed andbecause the actions of private foreign investors also mattered, he did not have a good sense of thetrue impact of foreign buying.16

The Bernanke Fed

Bernanke became chairman in early February 2006. He pledged continuity with theGreenspan era, and indeed he continued Greenspans measured, steady increases in the fed fundsrate, slowly raising it to 5.25% by the summer. But soon thereafter, everything hit the fan. In late2006, house prices (Exhibit 9) began to fall for the first time in decades. Growth expectations(Exhibit 5) began to turn down almost immediately. Oil prices were, at the same time,skyrocketing, putting Bernanke, an advocate of inflation targeting, in a difficult situation. In2008, he found himself wondering if he should tighten monetary policy to head off prospectiveinflation, or was the economy weakening quickly enough to naturally tame inflation (and, if so,would he have to loosen policy)?

15 Federal Reserve Chairman Alan Greenspan presented the Federal Reserve Boards Semiannual MonetaryPolicy Report to the Congress to the U.S. Senate Committee on Banking, Housing, and Urban Affairs on July 21,2005, 109th Cong., 1st sess., 2005.

16 For one estimate of the impact on U.S. interest rates of foreign buying of U.S. bonds, see Francis E. Warnockand Veronica Cacdac Warnock, International Capital Flows and U.S. Interest Rates, Journal of InternationalMoney and Finance 28 (2009): 90319.


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Events soon took over. The U.S. financial system, as it happened, was not sound. As inalmost any banking crisis, much of the lending in the preceding years was reckless, and theregulators were either ill-equipped to assess this or just uninterested. Capital flows into the

United Statessomething Bernanke had earlier worried might suddenly reversesurged in fall2008, as investors all over the world retreated from riskier assets. The United Statesand theentire world, it seemedwas mired in a deep recession. Inflation, once worryingly high (somuch so that there were food-price-related riots in almost 30 countries in 200708), was nowplummeting everywhere. And the U.S. federal budget, like budgets all over the world, was set togo deeper into deficit than at any time in recent memory.17

In the summer of 2007, the fed funds rate stood at 5.25%. Once the GFC began,Bernanke aggressively lowered the fed funds rate, quickly bringing it all the way to about 0% bythe end of 2008. The Fed also implemented an almost unfathomable campaign of new facilitiesto free up frozen credit markets and of credit easingto loosen monetary conditions even further.

As the financial crisis went through its worst periodin fall 2008 and spring 2009Bernankehad the Fed purchase over $1 trillion in mortgage-backed securities and Treasury securities in anunprecedented expansion of its balance sheet, all to try to stave off a depression. He referred tothis as credit easing; the market preferred the term quantitative easing.

Unfortunately, the GFC morphed into the euro zone debt crisis. This had a dual effect onthe U.S. economy. On one hand, the U.S. Treasury bond market was the beneficiary of safe-haven flows as investors realized that euro zone bonds were riskier than they had thought. On theother hand, uncertainty about the euro zone itself (was the monetary union going to dissolve?)led to uncertainty about the U.S. economy (would the U.S. financial system be dragged down bya disorderly breakup of the euro zone?). In late 2010, after the U.S. economy had emerged fromrecession but as it hit a soft patch, Bernanke announced that the Fed would embark on theunfathomable squared: QE2the second round of quantitative easing in which the Fed wouldbecome the proud owner of another $600 billion in Treasury securities by the second quarter of2011. Indeed, by some estimates, the Fed had surpassed the Peoples Bank of China as the singlelargest holder of U.S. Treasury securities.

Bernanke had received some criticism for QE1, but most people saw it as necessary tokeep the U.S. economy (and maybe even the global economy) from depression. The reaction toQE2, however, was fundamentally different. Some in Congress almost immediately called forthe abolishment of the Fed. William Gross, the legendary bond investor and head of PacificInvestment Management Co.better known as PIMCOlikened QE2 to a Ponzi scheme:

It seems that the Fed has taken Charles Ponzi one step further. Instead of simplypaying for maturing debt with receipts from financial sector creditorsthe Fedhas joined the party itself. Rather than orchestrating the game from on high, it has

17 For more on the U.S. economy amid the financial crisis, see Frank Warnock, Whither the U.S. Economy?,UVA-BP-0542 (Charlottesville, VA: Darden Business Publishing, 2009).


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jumped into the pond with the other swimmers. One and one-half trillion inchecks were written in 2009, and trillions more lie ahead. The Fed, in effect, istelling the markets not to worry about our fiscal deficits, it will be the buyer of

first and perhaps last resortI call [this] a Sammy scheme, in honor of UncleSam and the politicians (as well as its citizens) who have brought us to thiscritical moment in time. It is not a Bernanke scheme, because this is his onlyalternative, and he shares no responsibility for its origin. It is a Sammy schemeyou and I, and the politicians that we elect every two yearsdeserve all theblame.18

And Gross followed his words with actions. By March 2011, PIMCO, one of the largestbond investors in the world, had reduced its holdings of U.S. Treasury bonds to zero.

But Bernanke, undeterred, was not finished. In September 2011, in an effort to put

additional downward pressure on long-term interest rates, he implemented Operation Twist, inwhich, in order to extend the average maturity of its holdings of securities, the Fed sold short-term Treasury securities and used the proceeds to purchase longer-term U.S. bonds. InSeptember 2012, the Fed announced QE3: the FOMC would purchase $40 billion per month ofagency mortgage-backed securities, while at the same time continuing Operation Twist andreinvesting many of its ongoing principal payments into agency mortgage-backed securities. Alltold, QE3 would increase Fed holdings of longer-term securities by about $85 billion per month.

Why would the Fed aggressively purchase long-term Treasury bonds not just once (in thedarkest days of the crisis) but again with QE2 (when the economy was just in a soft spot) andyet again with Operation Twist? And why would the FOMC initiate QE3s move into mortgage-backed securities, a move Richmond Fed President Lacker derided as inappropriate credit policythat favored the very sector at the core of the GFC? Simple: Bernanke worried that long-terminterest rates would not remain low, thus dampening any incipient improvement in economicactivity. But he understood the substantial risks associated with a policy that was tantamount tomonetizing the budget deficit. Monetizing the governments budget deficit this way has been, formany countries, a sure path to high inflation. Bernanke knew this, and if he didnt, he could askany number of policymakers in countries ranging from Argentina to Zimbabwe.

The Bernanke Fed would go into the history books as being exceedingly aggressive, butsome of its new facilities and policies were not gaining traction. As a result, money growth wasnot increasing as much as the Fed had hoped because banks were hoarding excess reserves,keeping the money multiplier from increasing (Exhibit 10). To be sure, credit markets hadcalmed down; for example, the spike in interbank lending rates during the crisis seemed to be athing of the past (Exhibit 10). But the traction Bernanke had hoped for was not materializing.

18 William H. Gross, Run Turkey Run, PIMCOs November 2010 Investment Outlook,http://www.pimco.com/EN/Insights/Pages/RunTurkeyRun.aspx (accessed February 18, 2013).


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The Bernanke Fed was innovative on another front. At its January 2012 meeting, theFOMC published not only its forecasts for economic growth, inflation, and other importantvariablessomething it began doing the year beforebut also its forecast for the fed funds rate

(see Exhibit 11 for the latest projections). In the Greenspan Fed, access to internal fed fundsprojections was granted on a need-to-know basis, even for staff economists; the thinking withinthe Fed had changed so dramatically that the public was now privy to the Feds forecast of itsown future actions. This unprecedented amount of forward guidance was yet another attempt tokeep long rates low: if the market knew that the Fed had no intention of raising the fed funds ratefor the foreseeable future, that might be enough to keep long rates from rising.

The Dilemma in 2013

Like the previous five years, 2012 was a difficult year. In mid-2012, the economic

situation changed quickly, and not for the better. At its April 2012 meeting, the FOMC wasconcerned that the housing market continued to be held down (by the large overhang offoreclosed and distressed properties, uncertainty about future home prices, and tight underwritingstandards for mortgage loans) and that firms capital investment was slowing. Moreover, whilelabor market conditions seemed to be improving, there was far too much slack in the U.S.economy (Exhibit 12), and the official unemployment rate, underemployment rate, and thoseunemployed longer than six months were all too high (Exhibit 13).19 Those concernsnotwithstanding, in April 2012, the Fed thought the U.S. economic situation had improvedbecause real GDP growth had resumed anddespite substantial increases in commoditypricescore inflation remained subdued and longer-run inflation expectations were stable.

But by the August 2012 FOMC meeting, any hopeful words were taken out of the FOMCstatement.20 Its first paragraph, as usual, provided the Feds view of current economic conditions:

Information received since the Federal Open Market Committee met in Junesuggests that economic activity decelerated somewhat over the first half of thisyearthe unemployment rate remains elevated[h]ousehold spending has beenrising at a somewhat slower pace than earlier in the yearthe housing sectorremains depressed.

19 The underemployed include the officially unemployed plus people who are marginally attached to the laborforce (currently neither working nor looking for work but who indicate that they want and are available for a job andhave looked for work sometime in the past 12 months) and who are employed part time for economic reasons (wantand are available for full-time work but have had to settle for a part-time schedule). The underemployment rate isexpressed as a percentage of all potential workers (i.e., those in the labor force plus the marginally attached).

20 See Board of Governors of the Federal Reserve System, press release, August 1, 2012,http://www.federalreserve.gov/newsevents/press/monetary/20120801a.htm (accessed February 18, 2013).


13/30

-13- UVA-GEM-0111

Paragraph two was forward-looking:

The Committee expects economic growth to remain moderate over coming

quarters and then to pick up very gradually. Consequently, the Committeeanticipates that the unemployment rate will decline only slowly toward levels thatit judges to be consistent with its dual mandate. Furthermore, strains in globalfinancial markets continue to pose significant downside risks to the economicoutlook.

Taken as a whole, the statement was depressing: economic conditions are bad andexpected to stay that way, so much so that we might have to go to the well yet again.

After some FOMC meetings, Bernanke would take questions from journalists. Judging bythe questions he received at the April 25, 2012, press conference, some thought the Fed needed

to do more.

21

One journalist asked: Some of your criticsthink that youre still being toocautious, that unemployment is still high, the economy may be slowing, inflation is subduedisthe Committee now any closer to QE3? Another queried: How much more weakness wouldyou need to see for QE3 to be in place? And another asked:

Unemployment is too high, and you said you expect it to remain too high foryears to comeYou say that you have additional tools available for you to use,but youre not using them right now. Under these circumstances, its really hardfor a lot of people to understand why you are not using those tools right now.

The cries that the Fed was not doing enough continued at the June 20, 2012, post-FOMCpress conference:

How would you respond if, several years from now, a young MIT graduatestudent came forward and said, You know what the problem with Fed policy wasduring this period is it was too incremental, and that the reason why the economyunderperformed was because of that incrementalism.22

At that same press conference, others wondered whether the Fed was doing too much:

the Fed has already pushed interest rates to an extraordinarily low level, ahistorically low level, andthere isnt anything more that the Fed can do to helpthe recoverythe Fed at this point should stand down and let Congress or the

21 See Transcript of Chairman Bernankes Press Conference, April 25, 2012,http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20120425.pdf (accessed February 18, 2013).

22 Transcript of Chairman Bernankes Press Conference, June 20, 2012,http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20120620.pdf (accessed February 18, 2013).


14/30

-14- UVA-GEM-0111

White House attend to the economys ailments or let market forces attend to theeconomys ailments.

Bernanke took these criticisms (and others) seriously. But he knew that the U.S economy,while having emerged from recession, was not yet on firm footing. In April, the FOMC thoughtreal GDP growth would be about 2.5% in 2012. At the December meeting, the FOMC realizedthat 2012 growth would be more like 1.8% (Exhibit 11). Bernanke lamented the human toll thecrisis and the tepid recovery imposed. In his December 12, 2012, post-FOMC press conference,he noted that:

[U]nemployment remains high. About 5 million peoplemore than 40 percent ofthe unemployedhave been without a job for six months or more, and millionsmore who say they would like full-time work have been able to find only part-time employment or have stopped looking entirely. The conditions now prevailing

in the job market represent an enormous waste of human and economicpotential.23

This concern about unemployment was underscored in yet another change in Fed policy:the nature of the FOMCs forward guidance on the fed funds rate. In December 2012, it set forthquantitative criteria. Exceptionally low levels for the federal funds rate would likely bewarranted

at least as long as the unemployment rate remains above 6 percent, inflationover the period between one and two years ahead is projected to be no more thanhalf a percentage point above the Committees 2 percent longer-run goal, andlonger-term inflation expectations continue to be well anchored.24

The new year brought more difficulties. The late January 2013 flash estimate of real GDPgrowth suggested that the U.S. economy actually contracted at the end of 2012, and there weremany as-yet-unrealized risks. Oil prices, hovering around $100 per barrel, might spike evenhigher, pushing the U.S. economy back into recession andleading to more inflation. The eurozone was in recession; its crisis could yet enter a more dangerous phase. A third risk was that theU.S. Congress could manage to sabotage the economy. But after QE1, QE2, Operation Twist,QE3, , and publishing fed funds forecasts, what were Bernankes options?

For the time being, the Fed was staying the course and signaling it was ready to do more.Was its future policy overly constrained by the dissonance on the FOMC that journalists hadnoted? What was its exit strategy from current policy? And even while the Fed was embarkingon more purchases of long-term assets, it was at the same time seriously studying the opposite:when should it pare down its balance sheet and begin selling its $1.93 trillion holdings of U.S.

23 http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20121212.pdf.24 http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20121212.pdf.


15/30

-15- UVA-GEM-0111

Treasury securities and $1.21 trillion in mortgage-backed securities? Indeed, Bernanke surprisedmarkets in his June 2013 post-FOMC press conference:

If the incoming data are broadly consistent with this forecast [of gains in labormarkets and inflation around 2%], the Committee currently anticipates that it wouldbe appropriate to moderate the monthly pace of purchases later this year. And if thesubsequent data remain broadly aligned with our current expectations for theeconomy, we would continue to reduce the pace of purchases in measured stepsthrough the first half of next year, ending purchases around midyear.25

Before deciding when to pare back the Feds Treasury holdings, Bernanke wanted tomake sure he fully understood the factors affecting the current and prospective levels of U.S.long-term interest rates. How potential trends in inflation, growth, and other determinants of longrates would interact with the post-crisis environment weighed heavily on Bernankes mind as hewatched the sun set over the Lincoln Memorial.

25 Transcript of Chairman Bernankes Press Conference, June 19, 2013,http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf (accessed July 17, 2013).


16/30

-16-

U

VA-GEM-0111

Exhibit1

BE

RNANKESDILEMMA

EconomicIndicators

Notes:Surplus/deficitdata

areforfiscalyears.Alldataareannua

laverages.

Datasources:U.S.Bureau

ofEconomicAnalysis,U.S.BureauofLaborStatistics,U.S.CongressionalBudgetOffice,andHaverAnalytics.

1975-1984

1985-1994

1995-2004

2005-2007

2008-2009

2010

2011

2012

Grossdomesticproduct(billio

nsof$)

2,6

98

5,5

88

9,5

61

13,3

43

14,1

33

14,4

99

15,0

76

15,6

85

RealGDPgrowth(%)

3.0

3.0

3.3

2.5

-1.7

2.4

1.8

2.2

Personalconsumptionexpenditures

63

66

69

70

70

70

71

71

Durablegoods

9

9

9

9

8

7

8

8

Nondurablegoods

20

17

15

15

16

16

16

16

Services

35

41

44

45

47

47

47

47

Investment

17

15

16

17

13

12

12

13

NetExports

-1.0

-1.6

-3.2

-5.5

-3.9

-3.5

-3.8

-3.6

Exports

9

9

10

11

12

13

14

14

Imports

10

11

14

17

16

16

18

17

Governmentspending

20

20

18

19

21

21

20

20

-3.5

-3.9

-0.6

-1.9

-6.7

-9.0

-8.7

-7.0

Federalreceipts

18.2

17.9

18.6

18.0

16.4

15.1

15.4

15.8

Federaloutlays

21.7

21.8

19.3

19.9

23.0

24.1

24.1

22.8

Nonfarmbusinesssector

Compensationperhour

8.0

4.1

4.2

3.9

2.4

2.0

2.5

1.6

Outputperhour(productivit

y)

1.5

1.6

2.8

1.4

1.8

3.1

0.6

0.9

Unitlaborcosts

6.5

2.5

1.4

2.5

0.6

-1.0

2.0

0.7

PotentialGDP(billionsof$)

2,7

83

5,6

59

9,5

52

13,2

84

14,8

48.1

15,4

85

16,0

61

16,6

29

NaturalRateofUnemploymen

t(%)

6.2

5.8

5.1

5.0

5.2

5.4

5.5

5.5

UnemploymentRate(%)

7.7

6.4

5.1

4.8

7.5

9.6

8.9

8.1

PCEInflation(%)

6.9

3.3

1.9

2.8

1.6

1.9

2.4

1.8

(%ofGDP)

(%ofGDP)

(%change)


17/30

UVA-GEM-0111-17-

Exhibit 2

BERNANKES DILEMMA

Long-Term U.S. Treasury Yield and the Federal Funds Rate

Notes: Last data point: June 2013. The thick line represents the federal funds(effective) rate (percentage per year). The thin line represents the 10-year Treasuryyield at constant maturity (percentage per year).

10-Year Treasury Note Yield at Constant Maturity% p.a.

Federal Funds [effective] Rate% p.a.

1005009590Sources: Federal Reserve Board /Haver Analytics

10

8

6

4

2

0

10

8

6

4

2

0

fed funds10-year rate


18/30

UVA-GEM-0111-18-

Exhibit 3

BERNANKES DILEMMA

Short- and Long-Term Inflation Expectations

Notes: The thin line represents short-term (1 year ahead) inflation expectations. The thick line represents long-term(annual average for subsequent 10 years) inflation expectations. Last data point: 2013Q2.

Data source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters,http://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters/ (accessedJuly 10, 2013).

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

Inflation Expectations: Short and Long Termsource: Philly Fed Survey of Professional Forecasters

1yr ahead CPI inflation

10yr ahead CPI inflation


19/30

UVA-GEM-0111-19-

Exhibit 4

BERNANKES DILEMMA

Interest Rate Volatility

Note: Volatility is computed as the rolling 36-month standard deviation of changes in long rates.

Data sources: Author calculations based on data from Haver Analytics and Federal Reserve Board.

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Interest Rate Volatilityrolling 36-month standard deviation of changes in long rates


20/30

UVA-GEM-0111-20-

Exhibit 5

BERNANKES DILEMMA

Growth Expectations, One Year Ahead(percentage growth rate)

Note: Expectations are of the growth rate of real GDP over the subsequent four quarters.

Data source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters.

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Growth Expectations: 1yr aheadsource: Philly Fed Survey of Professional Forecasters


21/30

UVA-GEM-0111-21-

Exhibit 6

BERNANKES DILEMMA

Federal Budget Balance: Actual and Projections

CBO 'Baseline' Budget Balance

Fiscal Year, % of GDP

2015100500Source: Congressional Budget Office /Haver Analytics

2.5

0.0

-2.5

-5.0

-7.5

-10.0

-12.5

2.5

0.0

-2.5

-5.0

-7.5

-10.0

-12.5


22/30

U

VA-GEM-0111

-22-

Exhibit7

BE

RNANKESDILEMMA

U.S.Balanceo

fPayments(inbillionsofU.S.dollars)

Notes:A

lldataareannualaverages.Alldata,e

xceptmemoitems,areinbalanceofp

aymentsterms.

Datasou

rces:U.S.BureauofEconomicAnalysis,HaverAnalytics.

1975-1984

1985-1994

1995-2004

2005-2010

2011

2012

Current

AccountBalance

-14

-98

-331

-627

-458

-440

Tradebalance

-30

-94

-299

-624

-557

-535

Exportsofgoodsandservices

223

494

973

1,6

11

2,1

13

2,2

11

Importsofgoodsandservices

-253

-588

-1,2

72

-2,2

35

-2,6

70

-2,7

45

Income

balance

27

21

25

110

233

224

Incomereceipts

64

136

292

692

761

776

Incomepayments

-37

-115

-266

-583

-528

-552

Curren

ttransfers

-10

-25

-57

-113

-134

-130

CapitalAccountBalance

0

-1

1

3

-1

7

FinancialAccountBalance

-3

97

319

577

517

446

NetDI

Inflows

-2

0

-8

-65

-179

-222

ForeigndirectinvestmentintheU.S.

12

43

150

207

230

166

U.S.d

irectinvestmentabroad

-14

-43

-158

-273

-409

-388

NetPrivateSecuritiesFlows

5

23

187

192

-10

208

PrivateflowsintoU.S.securities

11

61

309

384

134

353

U.S.fl

owsintoforeignsecurities

-6

-38

-123

-192

-144

-145

Officia

lFlows

4

32

114

438

134

475

ForeignofficialflowsintotheU.S.

12

33

114

444

254

394

U.S.governmentassetsabroad

-7

-1

-1

-6

-120

81

NetBankingFlows

-12

32

12

5

516

-72

Statistic

alDiscrepancy

17

2

12

37

-93

-6

Memo:N

ominalGDP

2,6

98

5,5

88

9,5

61

13,7

99

15,0

76

15,6

85


23/30

U

VA-GEM-0111

-23-

Exhibit8

BE

RNANKESDILEMMA

ForeignO

fficialFlowsintotheUnitedSta

tes

(inbillionsofU.S.dollars)

200

3-2007

2008

2009

2010

2011

2012

Stockasof

2012Q3

Foreignofficialasset

sintheUnitedStates

381

555

480

398

212

374

5,615

Treasurysecurities

176

549

570

442

171

355

3,925

Agencysecurities

115

43

-133

-89

-12

-7

621

Bankdeposits

55

-150

-69

-8

30

2

204

Byarea:

Europe

54

-14

22

77

39

108

848

Canada

0

2

-5

2

4

2

26

LatinAmericaandC

aribbean

36

18

5

17

50

50

477

Asia

290

528

395

302

127

220

4,127

Africa

2

14

18

2

-12

-4

46

Other

-1

7

45

-2

4

-2

91

Datasource:U.S.BureauofEconomicAnalysis.


24/30

-24- UVA-GEM-0111

Exhibit 9

BERNANKES DILEMMA

Asset Prices

S&P/Case-Shiller Home Price Index: Composite 20

SA monthly data, annualized percentage change

1211100908070605040302Source: Standard & Poor's /Haver Analytics

30

20

10

0

-10

-20

-30

30

20

10

0

-10

-20

-30

S&P 500

year-over-year % change

1312111009080706050403Source: Wall Street Journal /Haver Analytics

60

40

20

0

-20

-40

-60

60

40

20

0

-20

-40

-60


25/30

-25- UVA-GEM-0111

Exhibit 10

BERNANKES DILEMMA

Recent Conditions in Credit and Money Markets

Money Stock: M2

year-over-year % change

1211100908070605040302010099Source: Federal Reserve Board /Haver Analytics

12

10

8

6

4

2

0

12

10

8

6

4

2

0

The Money Multiplier

M2/Monetary Base

1005009590858075Source: Haver Analytics

12.5

10.0

7.5

5.0

2.5

12.5

10.0

7.5

5.0

2.5


26/30

-26- UVA-GEM-0111

Exhibit 10 (continued)

TED Spread

3-month eurodollar rate minus 3-month TBill rate

100500Source: Haver Analytics

5

4

3

2

1

0

5

4

3

2

1

0


27/30

-27- UVA-GEM-0111

Exhibit 11

BERNANKES DILEMMA

FOMC ProjectionsApril 25, 2012, and June 19, 2013

2012 2013 2014 Long-Run

Real GDP Growth Apr. 2012Jun. 2013

2.42.92.2

2.73.12.32.6

3.13.63.03.5

2.32.62.32.5

Unemployment Rate Apr. 2012Jun. 2013

7.88.08.1

7.37.77.27.3

6.77.46.56.8

5.26.05.26.0

PCE Inflation Apr. 2012Jun. 2013

1.92.01.8

1.62.00.81.2

1.72.01.42.0

2.02.0

Shown are central tendency projections, which are mean forecasts excluding the lowest and highest threeforecasts. The top line in each cell is the projection as of April 25, 2012; the bottom line is the projection as of June19, 2013. The 2012 entry in the bottom line is actual 2012 data.

Note that at the June 2013 meeting, the majority of the FOMC members also predict the fed funds rate to be nearzero for the rest of 2013 and all of 2014. In 2015, nearly all foresee an increase in the fed funds rate. And theconsensus is that the appropriate long-run level of the fed funds rate is roughly 4.0%.

Data sources: Table 1 of Summary of Economic Projections, FOMC, April 25, 2012, and June 19, 2013,http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120425.pdf andhttp://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130619.pdf (accessed July 10, 2013).


28/30

-28- UVA-GEM-0111

Exhibit 12

BERNANKES DILEMMA

Slack in the U.S. Economy

US Real Gross Domestic Product: Actual (BEA) and Potential (CBO)SAAR, Bil.Chn.2005$

1110090807060504030201Sources: BEA, CBO /Haver

15000

14000

13000

12000

11000

15000

14000

13000

12000

11000

PotentialActual


29/30

-29- UVA-GEM-0111

Exhibit 13

BERNANKES DILEMMA

Labor Market Conditions

Un- and Underemployment Rateincludes Marginally Attached & Part Time for Economic Reasons

Unemployment RateCivilian, 16 yr +

100500959085Sources: Bureau of Labor Statistics /Haver Analytics

17.5

15.0

12.5

10.0

7.5

5.0

2.5

17.5

15.0

12.5

10.0

7.5

5.0

2.5

Unemployed for 27 Weeks and Over: % of Civilians Unemployed

SA, %

100500959085807570656055Source: Bureau of Labor Statistics /Haver Analytics

50

40

30

20

10

0

50

40

30

20

10

0


30/30

-30- UVA-GEM-0111

Exhibit 13 (continued)

Change in Total Nonfarm Employment

SA, Thous

1005009590858075Source: Bureau of Labor Statistics /Haver Analytics

1200

800

400

0

-400

-800

-1200

1200

800

400

0

-400

-800

-1200

Documents

Bernake's Dilemma