Ben Bernanke’s new gamble

Ben Bernanke’s new gamble

In an op-ed published in The Washington Post on Thursday, US Federal Reserve chairman Ben Bernanke has explained his reasons for buying another $600 billion worth of government bonds over the next eight months, apart from reinvesting repayments of the principal amounts received from agency debt and mortgage backed securities it already holds into treasury securities. The total purchases are expected to be around $850-900 billion, close to the top end of the market’s estimate of around a trillion dollars.

Bernanke’s article clearly says the aim of his programme of asset purchases, or quantitative easing (QE) as it is called, is to boost asset prices. The aim is to lower bond yields and boost stocks. In the words of the Fed chief, “lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

Whether this round of QE will work for the US economy is debatable. The earlier round of asset purchases did lead to higher stock prices and pushed down yields. But that didn’t result in a sustainable increase in either housing purchases or employment. Nor was it successful in raising inflation, which is another of Bernanke’s objectives. There is no reason to believe that QE2 will be any different. But if it doesn’t work, the likely response is going to be even more asset purchases. The Fed has hinted as much in its announcement, when it said that it will adjust the programme keeping in mind its effect on employment and price stability. With a fiscally conservative House of Representatives likely to curb further spending programmes, the burden of stimulating the economy falls solely on monetary policy. Unfortunately, the US is caught in a classic liquidity trap, where, in the absence of final demand, monetary easing does not lead to a growth in bank credit. After all, QE did not succeed in pulling the Japanese economy out of its quagmire.

In the circumstances, monetary easing will lead to dollars flowing out of the US into economies that are growing and into other hard assets such as commodities and precious metals. In short, instead of inflating US stocks and bonds, it’s very likely that the deluge of dollars unleashed by the Fed will find their way to emerging markets, leading to asset bubbles and higher inflation there. Our policymakers must get ready to face the challenge.

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