Bernanke must not push QE3 at Jackson Hole

Financial Times – Mohamed El-Erian is the chief executive and co-chief investment officer of Pimco

Ben Bernanke, the chairman of the US Federal Reserve, is in a really tough spot. With other policymakers essentially missing in action, many hope that he will provide a remedy for America’s increasingly deep-rooted economic problems at Jackson Hole on Friday. Possibilities include enlarging the Fed’s balance sheet, extending the average maturity of the financial assets it holds and, even more controversially, expanding the range of assets it buys in the marketplace. But Mr Bernanke is far away from the world of first-best policies. He operates with imperfect tools and has little support from other policymakers. He also faces an increasingly hostile political environment and recent history is against him. As such, expectations are far ahead of what he can reasonably deliver in terms of economic outcomes. At best, he could try to provide another bridge for other policymakers; but he should only do so if he is confident that they will finally awaken from their slumber.

It has been a year since Mr Bernanke last pulled a big rabbit from his policy hat. He did so at Jackson Hole where he set the stage for what became known as quantitative easing 2 – using the Fed’s balance sheet to buy financial assets, push up prices, make people feel richer and, hence, stimulate consumption, investment, jobs and economic growth.

Initially, markets responded enthusiastically as many investors extrapolated on the basis of Mr Bernanke’s success with QE1 in 2008-09. Yet QE2 was fundamentally different in design and, critically, in objective. Rather than follow QE1 in targeting the normalisation of dysfunctional financial markets, QE2 had a more ambitious economic objective – to minimise the risk of deflation and position America for renewed growth and price stability. In the event, QE2 pushed financial investors out of the risk spectrum and delivered higher asset prices. But it failed to convince companies and households to consume, invest and hire more. As a result the Fed-induced wedge between market levels and underlying fundamentals eventually collapsed under the weight of artificially high valuations. To be sure, Mr Bernanke was among the first to acknowledge that the benefits of unconventional policies come with costs and risks. Specifically, QE2’s benefits – in the form of “good” inflation (higher prices for equities and corporate bonds) – were coupled with collateral damage (“bad” inflation via surging commodity prices) and unintended consequences (technical market dislocations and the Fed becoming more vulnerable to political attack).

With America’s economy again losing momentum this summer, I suspect that Mr Bernanke feels a renewed urge for policy activism – both to meet the employment part of the Fed’s dual objectives and to relieve some of the mounting pressures on the financial system. However, I also suspect that he is aware of his reduced degrees of freedom, both in an absolute sense and relative to a year ago. Compared with August 2010, inflation is higher, structural impediments to job creation are deeper, the global environment is less co-operative, and the independence and credibility of the Fed are under greater pressure. Moreover, judging from the fleeting impact on risk sentiment of last week’s Federal Open Market Committee statement on interest rates, markets seem less sensitive to Fed shock therapy. All this serves to tilt Mr Bernanke’s policy equation towards greater costs and risks. Accordingly, rather than embark on another policy initiative (“QE3”) with questionable net benefits, it would be better for Mr Bernanke to use his Jackson Hole speech to reframe the national policy debate and, in the process, set the stage for President Barack Obama’s key economic announcements on September 5.

He should do so in three steps. First, acknowledge that the considerable headwinds undermining economic growth and jobs have important and growing structural elements. Second, explain why a sustainable solution must go well beyond Fed financial engineering and, specifically, incorporate co-ordinated structural reforms on the part of agencies responsible for housing, the labour market, public finances, infrastructure and directed credit. Third, and most delicate, caution that another round of unconventional Fed policies would only be effective if accompanied by these other policy initiatives. The time has come for the American policy narrative to be much more explicit about the structural challenges facing the country and, critically, set the stage for proposing to Congress a comprehensive package of self-reinforcing reforms. Mr Bernanke can facilitate this by using his Jackson Hole remarks as the warm-up act for Mr Obama’s critical speech on the economy next month. Anything beyond this would run the risk of the Fed building another costly bridge to nowhere.

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