“Economic growth has continued at a moderate pace so far this year,” began Federal Reserve Chairman Ben Bernanke’s testimony before the Joint Economic Committee on Wednesday morning. “Real gross domestic product is estimated to have risen at an annual rate of 2-1/2 percent in the first quarter after increasing 1-3/4 percent during 2012. Economic growth in the first quarter was supported by continued expansion in demand by U.S. households and businesses, which more than offset the drag from declines in government spending, especially defense spending.”
Wherever Bernanke goes, he can’t escape federal fiscal policy. The federal deficit and growing debt crisis have defined the post-crisis political environment in America. Ideological budget warfare has given birth to the sequestration spending cuts, which are arguably the largest drags on U.S. economic growth. Combined with the expiration of tax holidays and explicit tax increases, federal fiscal policy has co-dominated economic conversation in the U.S. alongside the Federal Reserve’s monetary policy, so it’s unsurprising that Bernanke would include it in the highest-level overview of the current economic situation.
The issue that Chairman of the Committee Congressman Kevin Brady (R-TX) pressed Bernanke the most about was the issue of when and how the Fed will exit its quantitative easing program. This question has been at the forefront of Mr. Market’s mind for pretty much the duration of the post-crisis equity bull run, because the Fed’s various QE programs have proven to be a tremendous stimulus for stocks. Without it, the entire economic landscape changes. When purchases begin to end, traders and investors will have to edit their strategies accordingly.
For some context on the scope of the QE program, the FOMC announced in a May 1 policy update that it had “decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”
This program has helped increase the size of the Fed’s balance sheet to over $3.3 trillion. The size of the Fed’s balance sheet is one of the primary concerns of the Fed and one of the most-used pieces of fodder among critics of the program.
Adopting another unconventional monetary tool, the Fed decided to explicitly link its policy decisions to the metrics tracking its dual mandate: employment, and inflation. At the beginning of the year, the Fed set a 2.5 percent inflation threshold and 6.5 percent unemployment target as the minimum criteria for a policy rate move. As St. Louis Fed President James Bullard said in a presentation earlier this week, “The adoption of threshold-based forward guidance was a clear improvement on the previous calendar-based forward guidance, which seemed to be plagued by the pessimistic signal problem.”
Bernanke summed up his feelings on inflation during the testimony by saying that, “if anything, [it] is a little bit too low.” Unfortunately, the same thing can be said of employment.
Besides GDP, the headline unemployment rate is closely monitored as a proxy for economic health. Lowering this rate is not explicitly the job of either monetary or fiscal policy, and policymakers have argued that job growth is primarily the responsibility of the private sector. That said, it is unarguably the responsibility of monetary and fiscal policy to create an environment that encourages the economic growth necessary to sustain job growth. As a result, the health of the labor market is the function of an awkward game of rock-paper-scissors played between the Fed, Congress, and the private sector.
With this in mind — that the Fed has explicitly linked its policy decisions to these economic metrics, and that monetary policy can only affect employment to a certain degree — Chairman Brady asked one of the most interesting questions of the entire hearing.
“My worry is that the Fed doesn’t have the prescription for what ails our economy,” said Brady. “A year ago, the Fed said that it wouldn’t set an employment target rate because it’s generally affected by non-monetary factors. But you’re unwinding the QE based on the employment areas that you have the least control of. What do we make of that?”
After addressing a leading statement about the slowness of the recovery (in which Bernanke cited fiscal policy as a significant headwind to growth, and defended aggressive monetary policy), Bernanke confirmed that monetary policy alone cannot directly influence the level of long-run unemployment.
“What we are trying to address here is the short-run cyclical gap,” he said. “We are seeing the economy operating at a level below what it is capable of operating at, and many people out of work who normally would have work, and monetary policy can help to put people back to work in the short run.”
Bernanke continued to say that in the longer run, increasing the potential growth of the economy is not really the Fed’s job, its the job of Congress. He cited the tax code and government spending on education and infrastructure as factors influencing long-term economic — and therefore employment — growth.
“Fiscal policy, at all levels of government, has been and continues to be an important determinant of the pace of economic growth,” Bernanke said later in his testimony. “Federal fiscal policy, taking into account both discretionary actions and so-called automatic stabilizers, was, on net, quite expansionary during the recession and early in the recovery. However, a substantial part of this impetus was offset by spending cuts and tax increases by state and local governments, most of which are subject to balanced-budget requirements, and by subsequent fiscal tightening at the federal level.”
Being members of Congress, the committee clearly recognized the role of fiscal policy — as separate from monetary policy — in economic growth. Bernanke also clearly identifies the dividing line between the two, and in his assessment of the current economic condition, called attention to the fiscal policy adopted by Congress.
“Fiscal policy at the federal level has become significantly more restrictive,” he said. “In particular, the expiration of the payroll tax cut, the enactment of tax increases, the effects of the budget caps on discretionary spending, the onset of the sequestration, and the declines in defense spending for overseas military operations are expected, collectively, to exert a substantial drag on the economy this year.”
“The Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1-1/2 percentage points during 2013, relative to what it would have been otherwise. In present circumstances, with short-term interest rates already close to zero, monetary policy does not have the capacity to fully offset an economic headwind of this magnitude,” he continued.
At the same time that these headwinds have brewed, Bernanke indicated that not enough has been done to encourage long-run economic growth — the foil to the pro-austerity position being argued all around the world. The short solution to this spending problem is to scale back short-term cuts in order to promote growth that will more substantially reduce deficits and debt in the longer-term.
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