Bernanke Tips His Hand

Federal Reserve Chairman Ben Bernanke must not want to keep the market guessing about monetary policy. In a speech on Friday, he practically announced that the central bank would take action to further loosen monetary policy at its next meeting. His remarks essentially served as an explanation of why the Fed is justified to take such action. At this point, it's really only a question of details.

This sentence, where Bernanke begins his discussion of monetary policy tools, makes the Fed's intentions crystal clear:

Given the Committee's objectives, there would appear--all else being equal--to be a case for further action.

Bernanke refers to the Fed's mandate no less than 13 times in the speech. He stresses that if employment isn't maximized and inflation isn't meeting its target, then the Fed must act. No one would legitimately be able to argue that unemployment isn't a problem right now, so that just leaves inflation.

At this time, deflation hasn't gripped the nation, but inflation is quite low. In fact, Bernanke and the other central bankers think it's too low. Their target is around 2%, while consumer prices inflation has declined to closer to 1% over the past year, as shown quite clearly by the September data released today as Bernanke was speaking.

Why is low inflation a problem? Bernanke explains:

In particular, at current rates of inflation, the constraint imposed by the zero lower bound on nominal interest rates is too tight (the short-term real interest rate is too high, given the state of the economy), and the risk of deflation is higher than desirable.

In other words, when inflation is very low and interest rates are also very low, then the Fed will have trouble keeping prices from falling if they begin to move downward, which is a real risk in an economy this slow. As we saw form the Fed's September meeting's minutes, most committee members are ready to act. Through this speech, it's pretty clear that Bernanke will lead a new quantitative easing effort to prevent prices from falling further and hopefully to increase employment.

How will the Fed do it? Bernanke outlines a couple options. It looks fairly likely that the central bank will again ramp up asset purchases. Although Bernanke notes the concern that the market's inflation expectations may rise too high as a response to this action, he brushes off the worry. He is confident that the Fed can act fast to lower those expectations if they become a problem.

He also mentions the possibility of the Fed providing additional communication on its plans to influence expectations. For example, the committee could be more specific about how long it will keep interest rates very low. He seems a little less excited about this option, as he only says that the Fed will continue to consider it. So it's clearly on the table, but it may only be employed after another asset purchase program has begun.

From Bernanke's speech it sounds almost certain that the Fed will begin further quantitative easing at its November meeting. That will probably take the form of purchasing additional longer-term securities to drive longer-term interest rates down further. The committee may also provide more specificity in its communication about interest rate policy.