Ben Bernanke’s reappointment as chairman of the Federal Reserve has been remarkably uncontroversial, given his role at the Fed as it failed to head off one of the greatest bubbles of all time.
But what matters now is how skillfully he exits the monetary stimulus he has put in place to avoid a banking and economic collapse.
With recent indicators around the world starting to point to a stronger-than-expected recovery, investors are right to begin thinking about the timing of future policy tightening.
The Fed’s balance sheet, in common with those of other central banks, has ballooned to more than $2 trillion. Some of this will unwind as banks make less use of liquidity lifelines and acquired assets naturally roll off.
But at some point, Mr. Bernanke will have to tighten policy via a combination of rate increases and actively shrinking the Fed balance sheet.
That is going to be tricky. If the Fed starts too early it could stop the recovery in its tracks. If the central bank moves too late, however, there is a risk that inflation expectations will get out of control. Investors also have to factor the wild card of whether Mr. Bernanke, at some point, feels the need to underline the Fed’s independence with some tough decisions that are politically unpopular.
These risks, however, aren’t symmetrical. Many economists argue the danger of acting too late is much lower than the risks of acting too early. As a keen student of the Great Depression, Mr. Bernanke is aware of the risks of choking off a recovery prematurely.
In the U.S., unemployment remains so high and capacity utilization so low that the economy is awash with spare capacity. It will take several quarters of above-trend economic growth before inflation becomes a problem, unless commodities soar much further.
Consumers remain weighed down by debt. And two of the main channels for the transmission of monetary policy aren’t functioning adequately: Credit growth remains low and market interest rates remain high in some areas. Economic growth could remain subdued.
So the likelihood is that Mr. Bernanke will keep monetary policy loose for a long time, confident inflation risks are overstated.
Indeed, the yield on Treasurys suggests the market expects inflation over the next 10 years to average 1.8%, well below the 2.5% average of the previous decade.
That leaves the risk of letting too much liquidity slosh around the system. Such an aggressive attempt to kick-start a moribund economy could end up again fueling asset-price bubbles, precisely the problem that got the world into such a mess. So far, Mr. Bernanke has given little indication of having a solution for this.
No wonder Wall Street is cheering.