Caixin, June 24, 2013
In his news conference after the Fed’s meeting last week, Chairman Ben Bernanke shook up financial markets when announced plans to end quantitative easing as soon as the unemployment rate falls below 7.0 percent. This was a sharp departure from past statements in which Bernanke seemed to imply that the end of quantitative easing was nowhere in sight. By contrast, the latest remarks suggest that just a small decline in the unemployment rate from the economy’s current 7.6 percent will be sufficient to get the Fed to pull back its support.
The new position is troubling because the economy still has a long way to go to make up the jobs lost since the beginning of the downturn. While there has been substantial drop in unemployment since it peaked at 10.0 percent in the fall of 2009, the story is much different with the employment to population ratio (EPOP), the percentage of people who have jobs. This fell from 63.0 in 2007 to a low of 58.2 percent reached briefly in 2010 and again 2011. It has only made up 0.4 percentage points of this drop, rising to 58.6 percent in the May data. This means most of the drop in unemployment is due to people giving up looking for work and dropping out of the labor force.
This drop corresponds to more than 9 million fewer people being without jobs. Some of the decline can be explained by the aging of the baby boom cohorts increasing the number of retirees, but the vast majority of the drop in the EPOP is attributable to fewer prime age workers holding jobs. This indicates there is still a large amount of labor market slack that is not showing up in the unemployment rate.
Ironically Bernanke made this exact point about declining EPOPs back in January 2004 when he was justifying the Fed’s decision to keep the federal funds rate at what was then considered an extraordinarily low 1.0 percent. Bernanke noted that the unemployment rate at the time was not terribly high, but pointed to a sharp decline in the EPOP from the pre-recession level. Since it was implausible that so many people had suddenly lost the desire or ability to work, Bernanke argued that the falling EPOP was strong evidence of continuing slack in the labor market. Apparently Bernanke views the recent fall in the EPOP differently than the drop following the last recession.
The economy is also well below its potential by other measures. Manufacturing industries are operating at 75.8 percent of capacity, 3 percentage points below the average of the last 40 years and almost 9 percentage points below the peak hit in the 1990s. The non-partisan Congressional Budget Office estimates that the economy is operating at almost 6 percent below potential GDP.
It is not clear how much impact the Fed’s decision to cut back its quantitative easing (QE) will have on the economy (the market’s fear of this cutback has already led to a jump in interest rates), and ending QE clearly goes in the wrong direction. The economy is likely to need all the help it can get for the immediate future. The impact of recent budget cutbacks is just now being felt. And, the economy had only been growing at a 2.0 percent annual rate, well below anyone estimate of potential growth, even before these cuts went into place.
It is also not clear what Bernanke could possibly fear on the other side. The core rate of inflation (excluding food and energy) has been 2.0 percent or less for the last four years. The most recent data actually show the inflation rate is falling.
Furthermore, modest increases in the rate of inflation would actually be desirable at this point. It would help to boost house prices, allowing underwater homeowners to gain equity. It would also have the effect of lowering real interest rates, something which the Fed cannot otherwise accomplish when its overnight interest rate has already been pushed to zero.
For these reasons it is not clear what goal Bernanke could possibly hope to advance by signaling his intention to end QE. There is no realistic basis for concerns about accelerating inflation and even if there was some modest evidence of inflation the Fed would be well-advised to simply accept it.
Ironically, Bernanke’s pullback may help to answer the question of what QE did actually accomplish. Most economists would acknowledge that it had some effect on lowering long-term interest rates, but the range of estimates is substantial. Some would put it as low as 0.1 percentage point, others as high as 0.7 percentage points. If we pick a mid-point of 0.4 percentage points, then it implies that millions of homeowners were able to refinance their mortgages at lower interest rates, freeing up money for consumption.
If we assume 60 percent of mortgage debt was financed at a lower rate as a result of QE, this would imply savings on the order of $20 billion a year. This would translate into close to 0.2 percentage points of GDP in additional demand. That’s not huge, but a modest step in the right direction. Lower interest rates also surely helped boost stock and housing prices, which would have an impact on the economy through the wealth effect on consumption. And there was likely some gain to trade as a result of a lowered value dollar.
On net, QE has probably only provided a modest boost to growth over the last four years, but in an economy that desperately needs demand, it is unfortunate to lose anything. Perhaps more importantly, it appears that Bernanke is prepared to join the coalition of complacent policymakers, as opposed to being an important advocate of stronger growth. That may be the biggest loss from his comments last week.