Bernanke Got It Right
Without the Fed's actions, Americans would be facing the same kind of deflation we suffered in the Great Depression.
Critics are attacking Ben Bernanke from all sides. Most recently, some have been arguing that the Federal Reserve chairman did a poor job of explaining how the central bank would cut back its massive bond-buying campaign, sending markets around the world into a tizzy. Before that, Bernanke's detractors argued that his aggressive monetary policies were producing bubbles in both the stock and housing markets and were setting the stage for damaging inflation in the future.
Yet a close look at the evidence reveals something quite different: The Fed's accommodative policy has helped the U.S. achieve one of the strongest recoveries among the developed nations. But the strength of the stock and housing markets is now based on fundamental economic developments, not just Fed policy.
The stock and housing markets are nowhere near bubble territory. Stocks are trading near their average historical ratio of price to earnings and are still cheap when compared with bonds and cash. And housing prices are still well below the bubble highs of 2005. Driving the housing market are record-low interest rates and record-high “affordability,” an index of mortgage costs relative to average family income.
It's hard to overemphasize the importance of the housing market and home prices to the health of the economy. Home equity is still the average American family's most important asset. And thanks to the rising stock market, it's far more pleasant to look at quarterly 401(k) statements than it was four years ago. Indeed, the recovering stock and housing markets are a major reason the U.S. economy is still growing while others are faltering.
Fed critics concede these points but argue that all the positive developments are the result of the low interest rates the Fed has engineered. But low rates also reflect fundamental changes in the economy—namely, slower growth and both aging baby-boomers and pension funds shifting money from stocks to bonds. Although rates will rise as the economy strengthens (indeed, the yield of the benchmark ten-year Treasury bond has climbed by almost a full percentage point since early May), it is likely that these powerful forces will keep them relatively low for years to come.
Critics also charge that the Fed's policy of flooding the banking system with reserves, which it uses to buy long-term government bonds, could cause inflation to surge. To be sure, the Fed has more than tripled its balance sheet and created nearly $2 trillion of excess reserves since the financial crisis. But when the time comes to unwind this liquidity, the Fed need not sell all its bonds. It could absorb most of the excess by raising the amount of reserves banks must set aside to cover deposits—a powerful monetary tool that has lain dormant for years. By raising required reserves, the Fed can begin tightening without unduly pressuring the bond market.
Prices under control. Despite all of the monetary easing, inflation has been declining, not increasing. Inflation has remained low because the liquidity the Fed created is not being spent. Rather, it's being held as excess reserves by banks, and businesses and individuals are hanging on to cash. Without the Fed's actions, Americans would be facing the same kind of deflation we suffered in the Great Depression, with disastrous economic consequences.
Moreover, it is wrong to argue that the Fed has abandoned its battle against inflation. Under Bernanke, the Fed established for the first time a long-term target for inflation (2%) and a short-term inflation trigger (2.5%) for when the central bank would begin to tighten monetary policy.
I have not agreed with all of Bernanke's actions. But I believe his strategy for dealing with the financial crisis was correct and that his current policy, which has garnered so much criticism, is the right response to a sluggish recovery. The gains we see now are based on improving fundamentals and rising consumer confidence. These gains will continue even when the Fed takes its foot off the monetary gas pedal.
Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania’s Wharton School and the author of Stocks for the Long Run and The Future for Investors.