by Neil Irwin
At the same time, inflation was low—and falling. Overall prices had gone on a wild ride in the preceding years as the price of oil and other commodities soared in the summer of 2008, plummeted at the end of that year with the global economic crisis, and then rebounded in the spring and summer of 2009. But by the middle of 2010, fuel prices weren’t the problem. There were now enough jobless workers that few Americans were getting wage increases. And there were so many idle factories and empty office buildings that companies had room to expand without pushing up prices. Fed officials had years earlier agreed that “price stability” means that consumer prices rise around 2 percent a year. In the twelve months ended in June 2010, the consumer price index rose only 1.1 percent, and even less than that when the volatile food and energy categories were excluded.
Perhaps more worrisome, investors and other economic decision makers were starting to conclude that very low inflation would be the new normal. Investors in the bond market were expecting inflation to average only 1.2 percent over the ensuing five years, based on the gap between bond yields that were and were not indexed to inflation.
People may not like it very much when prices for the goods they buy are rising, but if the Japanese experience shows anything, it’s that they experience more economic pain when prices and wages are falling. Large debts become even harder to pay off, so households hang on to their money rather than spend it, creating a vicious cycle in which less spending begets fewer jobs begets even less spending. Typically, a central banker could counteract low inflation and high unemployment by cutting interest rates and increasing the supply of money in the economy. But with the Fed’s target interest rate already stuck near zero, where it had been since December 2008, the typical tool wasn’t available. And that turned what would otherwise have been a simple decision into something rather more complicated.
But even as the data on the economy turned more negative, Bernanke stepped gingerly. Central banks tend to move slowly, not wanting to jar markets by overreacting to the latest economic report. That’s all well and good when policymakers have the right basic idea about what’s happening in the economy. In the summer of 2010, the Federal Reserve didn’t.
The official forecast of Fed policymakers, released that July, predicted the gross domestic product to rise at a 3.5 to 4.5 percent rate in 2011. The actual number turned out to be 1.6 percent. The Fed had underestimated the degree to which overhang from the boom years—the housing market crash, the blows to business confidence, the debts still being paid off—would prevent growth. But that was its projection, and the central bank was sticking to it, even as one data point after another seemed to prove it wrong.
“My colleagues on the Federal Open Market Committee and I expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years,” Bernanke told the Senate Banking Committee on July 21, 2010, in his semiannual testimony on monetary policy. He acknowledged that risks to growth were “weighed to the downside,” but, tellingly, spent almost a third of his time discussing how the Fed might exit from policies to support growth. He mentioned a nonexit strategy only when prompted by a senator’s question—and then only as a distant possibility. “If the recovery seems to be faltering,” Bernanke told Alabama senator Richard Shelby, “then we would at least need to review our options, and we have not fully done that review, and we need to think about possibilities.”
There was, among both Fed policymakers and the public, a large measure of “activism fatigue”—a sense that the government, including the central bank, had already done everything it could to try to stimulate growth, so a certain amount of patience was in order. Businesspeople were sitting on piles of cash and had easy access to the debt markets, so they didn’t see tightness of the money supply as a constraint on growth and hiring. Consumer spending was the big problem. “I could borrow two billion dollars tomorrow at three and a half percent,” David Speer, the chief executive of Illinois Tool Works, a sixty-thousand-employee industrial company, said in August 2010. “But what am I going to do with it?”
Bernanke had in fact weeks earlier urged Fed staff to begin studying subtle ways to ease the money supply. The Fed could cut the interest rate it paid banks to park cash from its already low 0.25 percent to something even lower, for example, or give the world a more explicit pledge to keep its ultra-low-interest-rate policies in place. (At the time, its statements indicated only that rates were expected to stay low for an “extended period.”) But at the July 21 hearing, Bernanke remained noncommittal.
“We have not come to the point where we can tell you precisely what the leading options are,” the chairman said.
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A week in advance of each of the Federal Open Market Committee’s eight meetings a year, senior Fed officials around the United States log in to their secure document server. There they gain access to the single most important piece of briefing material they need to review before the meeting. It has, since June 2010, been called the Teal Book. Before then, it was two separate documents, the Blue Book and the Green Book. If the document would be a merger of the two, so, the logic went, would the color.
Prepared under the watchful eye of the chairman, the Teal Book contains charts and narrative descriptions of what the Fed’s economics staff in Washington thinks is happening with the labor market, inflation, and so on, as well as what the staff forecasts the economy will do in the future. It also lays out three options for future Fed policy. Option A is invariably the dovish one, focused on trying to encourage growth by easing the money supply. Option C is the hawkish choice, focused on combating inflation by tightening the money supply. And Option B, falling somewhere in between the other two, is the one that the committee almost always ends up approving, albeit sometimes in modified form. After all, it’s the chairman and people who work directly for him who put together the options. Inevitably, the range of possibilities reflects both his own preferences and his best guesses as to what the variety of views on the committee might be.
On August 3, 2010, however, the day the Teal Book was to be posted to the secure server and seven days before the FOMC meeting, Fed officials scattered around the country learned of what might be on the agenda through a different means. The front page of the Wall Street Journal that Monday morning announced, “Fed Mulls Symbolic Shift.” The article, by staff reporter Jon Hilsenrath, said that Fed officials “will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.”
By long tradition, the small and insular club of journalists who cover the Federal Reserve regularly abide by what are known as “Fed rules.” Reporters can use information gained in interviews with high-ranking Fed staffers, but they can’t attribute it in any way—not even to “a senior Fed official.” Instead, they write what they know in a strangely omniscient voice, giving no hint of how they know it. So even though Hilsenrath’s story gave no clue as to where his information came from, it seemed a safe assumption, both to people across the Federal Reserve System and to those in the community of analysts who monitor the central bank, that his main source was either Bernanke or someone with intimate knowledge of the chairman’s thinking.
In this case, Fed policymakers around the country suspected they were learning of a new policy move from their morning newspaper. Sure enough, when they logged in to the secure document server to examine the Teal Book, Option B called for the Fed to ease monetary policy a bit, in the manner Hilsenrath had described. In a coffee break at the meeting the following week, some policymakers complained to Bernanke’s communications adviser, Michelle Smith, that the press had gotten wind of an imminent policy shift before many of them had.
So what happened between July 21, when Bernanke gave no hint that the Fed would be acting, and August 10, when the FOMC met? There was another weak jobs report in that sp
an—but that was released on August 6, after both the Wall Street Journal story and the Teal Book had been issued. What actually provoked the change was new evidence compiled by analysts at the New York Fed of what would happen in the absence of an adjustment to Fed policy. After pushing interest rates to zero at the end of 2008, the Fed took its first step toward unconventional monetary policy with QE1, using newly created money to buy up mortgage-backed securities issued by government-sponsored companies like Fannie Mae and Freddie Mac and funded by ordinary Americans’ home loans. It was meant to simultaneously expand the money supply and funnel funds to the cash-starved mortgage sector.
The result was that the Fed owned $1.1 trillion worth of such securities by the summer of 2010. But the bank’s policy at the time was that as those bonds matured—as people refinanced or paid off their mortgages—it wouldn’t buy new ones to replace them. Instead, it would allow the amount of money it was pumping into the financial system gradually to decline.
But the economy was weakening that summer, and interest rates fell as investors plowed money into the safe haven of mortgage bonds effectively guaranteed by the U.S. government. Lower mortgage rates meant that people who had home loans ultimately funded by the Fed had incentive to refinance their mortgages. When they did, and the central bank didn’t buy replacement mortgages, the Fed was in effect sucking money out of the financial system—the exact opposite of what it wanted to be doing when the economy was looking bad. New York Fed president Bill Dudley’s staff had initially estimated that the mortgage securities portfolio was on track to shrink by $200 billion by the end of 2011. When it revised that number in light of the drop in rates, it came up with $340 billion—an extra $140 billion that the Fed would be pulling out of the economy at a time when the outlook was getting weaker.
To stop that unintended tightening, the FOMC would need to pull an about-face on its policy. Just before the August 10 meeting, Bernanke changed its start time from 9 to 8 a.m. so the committee would have more time to discuss the possibility.
There were clearly a number of factions among the committee members. One group, including Eric Rosengren of the Boston Fed, Charles Evans of Chicago, and Janet Yellen of San Francisco (who had been nominated as the new Fed vice chairman but not yet confirmed), saw the economy slipping and thought the central bank needed to move aggressively to try to stop it. Changing the mortgage-bonds reinvestment policy, they argued, should be merely the first action in a broader campaign to pump money into the economy. The mainstream of the committee, including Bernanke, Vice Chairman Don Kohn, and a number of governors who tended to follow the leader, saw the change as a necessary measure but didn’t believe it should necessarily lead to further moves toward easy money. It was a reverse, certainly, but just a technical one—not really a big deal.
Another set of policymakers, including Bernanke intimate Kevin Warsh and Governor Betsy Duke, had significant reservations but found it hard to argue against the narrow logic of changing the reinvestment policy to avoid a “shadow tightening.” Of the four inflation-hawk reserve bank presidents who were dead set against the change, Richard Fisher, Jeffrey Lacker, Charles Plosser, and Tom Hoenig, only perpetual naysayer Hoenig had a vote that year.
So the decision to change the reinvestment policy, announced right on schedule at 2:15 p.m., became a Rorschach test for Fed officials: Those who wanted to begin a major easing of policy could believe it was the start of just that; those who didn’t could view it as just a tiny technical change.
That ambiguity may have helped Bernanke build consensus on his committee, but it created nothing but confusion in the outside world. Had the Fed changed its view that the recovery was on track? Was the action the start of something big, or just a one-off tweak? The people whose job it is to analyze what the Fed is up to had no idea, and quirks of the calendar made it hard for them to find out. Many of the policymakers who would typically explain themselves in postmeeting speeches were on vacation. The first to discuss the decision was Minneapolis Fed president Narayana Kocherlakota, the newest FOMC policymaker. He was so new, in fact, that Fed watchers were still unsure of where to place him on the scale from dove to hawk.
On the reinvestment decision, Kocherlakota was among those in the moderately hawkish camp who went along because they viewed the policy change as a one-off. That’s what he told the world in an August 17 speech at Northern Michigan University—then added that the decision had a “larger impact on financial markets than I would have anticipated.” The next Fed insider to address the issue publicly was St. Louis Fed president Jim Bullard, another relative newcomer and one known for his idiosyncratic views on monetary policy. (He both opposed the pledge to keep interest rates low for an extended period and been warning of the risk of deflation in a paper ominously titled “Seven Faces of ‘the Peril.’”) He seemed more open to a large-scale, programmatic move toward easier money, saying that new action “may be warranted.” After Bullard came Hoenig, who yet again warned of the perils of keeping rates too low for too long.
The people who work in the financial markets and make or lose fortunes on the central bank’s every action didn’t know which end was up. “The chatter you’re getting around policy right now is such a cacophony,” said Ethan Harris, an economist with Bank of America–Merrill Lynch. “There’s just a bunch of wildly different views being presented from both inside and outside of the Fed, and that is confusing markets.”
For clarity, the world had no one to look to but Ben Bernanke.
• • •
The chairman’s speech at the Kansas City Fed’s annual Jackson Hole conference always receives a great deal of attention, from the speechmaker as well as the audience. Bernanke each year pours dozens of hours of both his own time and that of his staff into getting his message just right. (Ironically, for all the extra attention, it’s the only speech Bernanke gives that’s not broadcast on television; only a text is released.) Earlier in the summer, he’d planned to offer a rather academic talk on current account balances. But that speech was scrapped and a new one, aiming to give the world a thorough explanation of what the Fed was thinking, was hammered out in time for the late August conference.
In the early days of Bernanke’s chairmanship, staffers would write the first drafts of his speeches. But he found himself revising so extensively that by 2010 he wrote first drafts himself, then handed them over to staff to check and revise his data and analysis. For the 2010 Jackson Hole speech, he took a much more collaborative approach. His planning involved not just the usual discussions with his closest aides, but a series of meetings that amounted to a framing of their entire strategy for monetary policy. The meetings included Kohn, who was set to step down as vice chairman and leave a forty-year career at the Fed four days after the speech, Warsh, Michelle Smith, and the heads of the Fed’s two major economics research departments: Bill English of monetary affairs and David Stockton of research and statistics. In Bernanke’s office, the discussion evolved until it wasn’t just about how best to communicate to the world what the Fed had done, but also about whether the Fed should do more at all.
In the Federal Reserve System, as in all modern central banks, it is a committee that formally decides how to best steer an economy toward the happy middle ground between inflation and recession. But even though the Fed chairman has only one vote out of twelve, his true power goes far beyond that. He sets the agenda and frames the options on the table. He guides the discussion toward directions he believes useful and away from those he disfavors. And seven of the twelve voters at each FOMC meeting are governors based in Washington, who frequently feel an institutional loyalty to vote with the chairman even if they have reservations. Those deliberations about the Jackson Hole speech were really about Bernanke making up his mind.
Of those in the room for this innermost of circles, Warsh, a onetime investment banker turned White House staffer who had been the youngest Fed governor in history when President George W. Bu
sh appointed him in 2006, most consistently argued against a new program of easing. What was wrong with the U.S. economy, according to Warsh’s line of reasoning, wouldn’t be fixed by pumping more money into it. There was the overhang of housing from the boom years and a glacially slow process of foreclosures that was preventing the market from clearing, the debts weighing on households, the retrenchment of state and local governments. With short-term interest rates near zero, Americans could already obtain a thirty-year fixed-rate mortgage for an interest rate of around 4.4 percent, far below any longer-term historical average, and creditworthy businesses could borrow at similarly low rates to buy equipment or build a factory.
It wasn’t at all clear that injecting an extra few hundred billion dollars into the economy would encourage more economic activity. And it would come with risks, too: If the Fed owned too much of the federal government’s debt, it might disrupt the American bond market, the biggest in the world. Would the market function properly if private buyers were essentially pushed out? Would they return once the Fed was ready to back away? Could yet another round of activism by the Fed make the central bank vulnerable to attacks by elected officials who were wary of government involvement in the economy? And could that actually undermine confidence among businesses?
As Warsh mounted those arguments against new action, Bernanke and Kohn countered with a much simpler logic. The Fed’s job, as dictated by Congress, is to try to ensure stable prices and maximum employment—the “dual mandate,” as it’s known. Prices were rising more slowly than the 2 percent that most Fed leaders viewed as stable. And the job market wasn’t rebounding anywhere near as quickly as anyone had hoped. Therefore, Bernanke and the Fed’s task was to find a way to pump more money into the economy, even if they couldn’t be sure just how much of an effect it would have.
