The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Bernanke was in particular a subscriber to a “tipping point” theory of how the economy works. The U.S. economy is capable of growing somewhere around 2 or 2.5 percent each year simply due to an expanding labor force and rising worker productivity. That means that slower growth, if sustained, could create a vicious cycle: more people unemployed, driving down incomes, driving down demand for products, leading to more layoffs, and voilà, an economy back in a recession, or even an outright contraction. If the Fed could give the economy just enough of a push to get it over that 2.5 percent growth hurdle, the reverse might set in: a virtuous cycle of falling unemployment, rising incomes, more demand, and more hiring. One little nudge from the Fed might make a great deal of difference.

  The most recent report on growth at the time had shown a 2.4 percent rate of expansion in the spring of 2010—in other words, right on that line where, if Bernanke’s tipping-point premise was correct, a little bit of a push in the right direction could go a long way. Yes, cheaper money might not help growth as much as it could without the counterinfluences of mortgage market dysfunction and debt overhang. But it could probably help on the margins.

  And if the Fed did squeeze private investors out of the Treasury bond market, he argued, they would have to put their money elsewhere, affecting the economy through what is known as the portfolio balance channel. They might buy corporate bonds, which would mean still more money available for companies looking to expand. They might buy mortgage securities, which would make it cheaper for Americans to buy or refinance a house. Or they might invest in the stock market, pushing up share prices and, in the process, household wealth.

  By the end of these sessions—half a dozen in total—Bernanke and his closest advisers had drafted a speech that laid out the decision of whether to do another round of quantitative easing as one of costs versus benefits. “As we return once again to Jackson Hole, I think we would all agree that, for much of the world, the task of economic recovery and repair remains far from complete,” Bernanke, yet again standing under the elk-antler chandeliers at the Jackson Lake Lodge, said to the 110 or so people gathered in the ballroom. Many thousands more around the world read the text of the speech as it was published simultaneously online.

  Bernanke very much raised the possibility of new action but stopped far short of pledging it. “The committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly . . . the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.” In other words: QE2 was very much on the table, but it would only be enacted if conditions deteriorated further.

  “Fed Ponders Bolder Moves” was the Wall Street Journal headline; “Bernanke Pledges Dramatic Steps If Economy Worsens,” said the Washington Post. That was the public perception. Those who had been privy to the writing of the speech had a different view. The Fed chairman would never have said so explicitly, but from the Jackson Hole speech forward, the task at hand was to figure out how best to pump more money into the economy and build support for drastic action on the committee. The Bernanke that advisers saw in those private sessions was a man who had made up his mind that the Fed was going to do something—and something big. He just had to figure out how to make it happen.

  Barely three weeks after the Jackson Hole speech, the FOMC was due to meet again, once more against a backdrop of gloomy economic news. The August jobs report, released September 3, showed another month of anemic private job creation and an unemployment rate that had ticked up to 9.6 percent, yet another sign of a sputtering economic expansion. Around the country, when the presidents of Fed banks logged in to the secure document server in advance of the September 21 FOMC meeting, they found that Option B again tilted toward easier money.

  This time, at another rushed one-day (really one-morning) committee meeting, the consensus was that the apparent low inflation and weak growth warranted moving toward looser monetary policy. But there was no agreement on how to pursue it. Bernanke didn’t force the issue. Instead, he encouraged the committee members to signal the things they could agree upon in the statement released after the meeting: that inflation was “currently at levels somewhat below” what the committee views as best, and that the Fed “is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” Translation: We’re on the verge of doing something, even if we don’t know yet what it is.

  Incrementalism proved a useful method for bringing more Fed policymakers around to Bernanke’s point of view. It allowed time for more evidence to mount that the economy was indeed stuck in neutral, as well as for those officials who had reservations about a new policy to believe that their concerns were given a fair hearing. Meanwhile, Bernanke’s inner circle was changing: Kohn, the walking institutional memory of the Fed, who had been right-hand man to Alan Greenspan and then vice chairman under Bernanke, had retired on September 1. Obama had appointed Janet Yellen to replace Kohn as vice chairman, and although she wouldn’t be confirmed until October 4, she had already moved to Washington. And she was decidedly dovish—one of the committee’s strongest advocates for the idea that with the economy underperforming and inflation not much of a threat, greater activism was warranted.

  Bill Dudley, who had succeeded Timothy Geithner as president of the New York Fed, also believed that the central bank needed to do more to boost the economy. Even better, he knew the practical, nuts-and-bolts details of how to carry that out, which ensured that any desire to ease policy wouldn’t run up against technical problems identified by “traders,” as the New York Fed’s markets desk calls them, who buy and sell securities in order to carry out Fed policies. Dudley had previously run that operation, so he knew well what challenges awaited in execution. With Kohn gone and Warsh firmly against new monetary easing, Yellen and Dudley became Bernanke’s closest collaborators.

  On October 1, Dudley gave a speech that left little doubt that something significant was on the way. Speaking to the Society of American Business Editors and Writers, he described how the Fed was failing in both encouraging job creation and in keeping inflation at its target rate, explaining how buying bonds might improve things on both fronts. He even raised a relatively controversial idea that had been often mentioned by academics but rarely by policymakers: that a central bank might respond to inflation that’s too low by allowing some period of “catch-up” inflation. He then offered a conclusion that included none of the understatement, jargon, or circumlocution that are standard whenever senior central bankers talk about what they might do. “My assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable,” Dudley said. “We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted.”

  Fed watchers in financial markets often overestimated how much FOMC members coordinate their speeches. Contrary to common assumption, presidents of the reserve banks around the country don’t generally run their speeches by Bernanke and his colleagues in Washington, let alone take marching orders. They act on their own. But when Dudley speaks, it’s a little different. By long tradition, the New York Fed chief is vice chairman of the FOMC, and with that comes a responsibility to ensure he isn’t getting too far out of step with what the majority of the committee—and its chairman—is thinking. For that reason, Dudley’s speech came very close to preannouncing QE2.

  Bernanke had successfully built a consensus that some sort of easing made sense; he and his allies now set out to shift the discussion toward how as opposed to whether. As if to underscore that shift, three days after Dudley’s speech, his key deputy, Brian Sack, who ran the
Fed’s markets desk and would be the official charged with carrying out the new easing program, gave a talk of his own. With the intentionally bland title “Managing the Federal Reserve’s Balance Sheet,” the speech explained the technical challenges of a new round of bond purchases and how the New York Fed markets desk was overcoming them. Although Sack didn’t express his own view of whether a new purchase program was warranted the way Dudley had a few days earlier, the simple fact that he was discussing the issues involved at such length gave another hint about where the FOMC was going. After all, why spend hundreds of words explaining a policy that isn’t going to be enacted? The hawks on the committee were particularly annoyed; they were forever being told not to front-run the committee by speaking about what it might do; now Dudley and even Sack, not a member of the committee at all but a staff member, were doing just that. “It was quite upsetting to me,” said Tom Hoenig, “to have the head of the Reserve Bank of New York—and the money desk guy—out there defining what the moves are going to be.” Hoenig and others made their objections known to Bernanke. “By that time I wasn’t going to wait until [the FOMC meeting]” said the Kansas City Fed chief. “I’m pissed.”

  It was a wet, cold, and gloomy New England morning when, promptly at 8:15 a.m., Boston Fed president Eric Rosengren called to order the bank’s annual research conference on October 15, 2010. Eleven years earlier, the Boston Fed had brought many of the same economists together in Woodstock, Vermont, to discuss “Monetary Policy in a Low Inflation Environment.” There, Princeton professor Ben Bernanke had argued that Japan was failing to ease monetary policy sufficiently out of “self-induced paralysis.” Now, revisiting the same topic, the question on the table was whether the Bernanke Fed was stuck in a paralysis of its own. In his keynote address, Bernanke left few doubts of where he stood. “Given the committee’s objectives, there would appear—all else being equal—to be a case for further action,” the chairman said that morning, his words carried live on all the financial news channels. Acknowledging that there can be downsides to unconventional policy steps, he added that “the Federal Reserve remains committed to pursuing policies that promote our dual objectives of maximum employment and price stability.”

  Bernanke left the conference soon afterward to fly back to Washington. In the hours that followed, leading academic economists debated the theoretical challenges of easing the money supply when short-term interest rates are already at zero. The challenge of the situation that the Bank of Japan found itself in a decade earlier, and that the Fed now was grappling with, was that it couldn’t cut rates to the point where they would be low enough to stimulate investment, below the so-called zero lower bound. Some grappled with the mind-bending question of why rates can’t go below zero. What if the Fed tried to set a negative interest rate—that is, effectively levying a tax on savings? Said Greg Mankiw, a Harvard economist and former White House adviser, at the Boston conference, “What a depositor is going to do is say, ‘Well, if they’re going to charge me money to keep my money at the bank, I’m just going to keep my money at home,’ and the only thing you’ll generate is a demand for safe assets—and by that I mean assets that are safes because they’re going to be buying a bunch of safes so people can put their money in their safes rather than in the bank.” He added that one way around that problem, suggested by a student, would be to declare currency with certain serial numbers invalid. “I won’t say who he was,” Mankiw said. “Because he may want to be a central banker one day.”

  While the academics talked in a conference space next to the Boston Fed’s cafeteria, the senior Fed officials in attendance quietly slipped out at around 2:30 p.m. and took an elevator upstairs to Rosengren’s office suite. There, they logged in to a secret video teleconference of the Federal Open Market Committee. The regularly scheduled FOMC meeting was still two weeks away, and the idea that there would be a QE2 was fully expected by the market after Bernanke’s speech that morning. But the chairman wanted to hold this session to ensure plenty of time to discuss the technical details of how to carry out the program. Should the Fed announce one giant number up-front for the amount of Treasury bonds it would buy, say $500 billion or $800 billion? Or should it revisit it at every FOMC meeting, for example, starting with $100 billion and then either announcing another $100 billion or cutting the number to zero depending on what the economy did in the interim? (This was the approach favored by St. Louis Fed president James Bullard.) A final option, which drew some interest from Bernanke but never took off among fellow committee members, would be to target some particular longer-term interest rate and then buy bonds in whatever amounts necessary to hit that target. The attendees also debated whether the Fed needed to improve how it communicates its goals to the public, such as by making its target for inflation more explicit or having Bernanke begin holding press conferences.

  The three-hour conference had the practical purpose of determining which strategies had wide support among committee members and which didn’t. But it was also one of the last acts in a strategy that had combined persistence with patience. Between the August and September FOMC meetings, the smaller sessions in Bernanke’s office, and this special videoconference, the QE2 decision had been so fully aired that by the time the November 2–3 policy meeting rolled around, no one on the committee could have argued that his or her voice had gone unheard. Bernanke, from that August meeting on, had been constantly pushing toward new easing, even while giving his more recalcitrant colleagues time to come around to his view. Before taking this new plunge into unconventional monetary policy, however, he had a few more people to convince: the finance ministers and central bankers of the twenty most powerful nations on earth.

  Located in the southeast corner of South Korea, with no airport of its own, two hours by train from Seoul and an hour by car from Busan, the small city of Gyeongju was, for most of the officials scheduled to meet there for the Group of 20 economic summit on October 22 and 23, 2010, rather difficult to get to. Bernanke had wanted to skip the meeting entirely. With round-trip travel, the two days of meetings occupied five days on his schedule. (The Fed chairman usually flies commercial; if he were to routinely catch a ride on the treasury secretary’s Air Force jet, it could be seen as compromising the central bank’s independence.) But in the interest of diplomacy, he needed to explain the imminent QE2 to the world.

  It was an unwieldy gathering: Each of the twenty member nations sent its finance minister plus its central banker. Each of those forty officials brought a deputy. Some also had interpreters. And there were various “honorary” attendees, ranging from international groups like the International Monetary Fund and the World Bank to larger non-G20 countries like Spain and Vietnam. All told, there were around a hundred people in the room, hardly an intimate gathering.

  The South Korean finance minister began, welcoming the attendees and taking care of administrative announcements. Then, by long tradition, the United States was given the floor, asked to explain what was going on with the world’s largest economy. Normally, Treasury Secretary Geithner would have dominated this part of the discussion, but this time he gave the prime speaking role to Bernanke, who set out to explain the policy move that by this point it was widely expected the Fed would soon take. He and Kevin Warsh, there as Bernanke’s deputy, worried that the briefing could prompt political criticism: Why should the Fed involve the rest of the world in a domestic policy decision? So Bernanke took care to say only that the Fed was likely to consider new asset purchases, without suggesting that it was an absolute certainty. Still, who knew what that might sound like through the filter of a journalist speaking to a foreign official?

  The possible move, he said, was about adjusting U.S. monetary policy to properly match U.S. economic conditions. It wasn’t about trying to manipulate the value of the dollar, even if a reduced value of the dollar on foreign exchange markets was one likely result. I’m not trying to start a currency war, Bernanke argued, I’m just trying to stop deflatio
n and economic contraction from taking hold in the United States.

  Several of the officials in the room—from the same countries who would raise vocal public objections three weeks later—were having none of it. The Germans argued that the Americans were tempting inflation on a mass scale and new financial bubbles, which to Bernanke just sounded like the usual German hard-money fetishism. The Chinese and Brazilians argued that the hundreds of billions of dollars the Americans would soon unleash would find their way into oil markets, driving up energy prices, as well as into stock markets in emerging economies that were already dealing with vast inflows of “hot money” and a risk of bubbles. Bernanke was sympathetic to the Brazilians, though less to the Chinese: All they had to do to avoid importing inflation from the United States was to end their policies of intervening in markets to depress the value of their own currency relative to the dollar, which was exactly what the United States government wanted them to do. The emerging markets’ arguments, in Bernanke’s view, boiled down to the idea that the U.S. government should do what was best for them, not what was best for the U.S. economy.

  • • •

  As they do eight times a year, the men and women of the Federal Open Market Committee who came to Washington from out of town for the two-day meeting that was to begin on November 2 checked in to the Fairmont Hotel, then piled into vans for the mile-long drive to the Eccles Building. The financial news networks were in full hyperventilation mode, alternating between assessing the impact of massive Republican wins in congressional elections that Tuesday and the QE2 announcement expected the next day. They parked their satellite trucks around the Fed’s building in Foggy Bottom; there would be nothing to report until Wednesday afternoon when the meeting concluded, but having the white marble edifice of the Fed’s headquarters behind their reporters lent gravity to the broadcast.