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Beware the impact of returning to normal

by Kenneth Rogoff

At the U.S. Federal Reserve’s recent and first-ever public press conference, Chairman Ben Bernanke gave a spirited defense of the Fed’s much-criticized policy of mass purchases of U.S. government bonds, or “quantitative easing.” But was his justification persuasive?

Most economists viewed his performance as masterful, but the fact that the dollar has continued to slide while gold prices have continued to rise suggests considerable skepticism from markets. One of the hardest things in central banking is that investors often hear a very different message from that which the central bank intends to send.

The Fed, of course, has been forced to turn to “Q.E.,” as traders call it, because its normal tool for fine-tuning inflation and growth, the overnight interest rate, is already zero.

Yet U.S. economic growth remains sluggish, and is accompanied by stubbornly high unemployment. Q.E. has been blamed for everything from asset-price bubbles to food riots. Everyone from foreign finance ministers to cartoon satirists has ripped into the policy.

Critics insist that Q.E. is the beginning of the end of the global financial system, if not of civilization itself. Their most telling complaint is that too little is known about how quantitative easing works, and that the Fed is therefore taking undue risks with the global financial system to achieve a modest juicing of the U.S. economy.

Whether the critics are right or not, one thing is clear: With the Fed lagging other global central banks in the monetary-tightening cycle, and with rating agencies contemplating a downgrade of America’s credit score, the U.S. dollar’s purchasing power has sunk to an all-time low against the currencies of trading partners.

Bernanke’s defense at the press conference was robust and unequivocal. He argued that Q.E. is not nearly as unconventional as its critics claim.

If one looks at how it has affected financial conditions, including long-term interest rates, volatility and stock prices, Q.E. looks an awful lot like conventional interest-rate policy, which we think we understand. Thus, concerns about Q.E.’s supposed ill effects are wildly overblown, and there is nothing especially challenging about eventually reversing course, either.

Bernanke dismissed complaints about commodity prices and emerging-market inflation, arguing that these phenomena had far more to do with lax monetary policies and overly rigid exchange rates in fast-growing developing economies.

The Fed chairman’s comments come at a critical and sensitive moment. Over the next year or so, the Fed is likely to enter a tightening cycle, raising interest rates on a steady and sustained basis. It does not want to rush, because the U.S. economy is still weak, with first-quarter growth a lackluster 1.8 percent But it cannot wait too long, lest inflation expectations drift to a dangerously high level, forcing the Fed to move aggressively — and at the cost of considerable economic pain — to wring inflation out of the system.

In unwinding Q.E., Bernanke must avoid another land mine, namely an unwelcome collapse in asset prices. Many savvy Wall Street traders are convinced that Q.E. is just the old “Greenspan put” on steroids. The cult of the “Greenspan put” stemmed from the previous Fed chairman’s avowed belief that the Fed should not try to resist a sharply rising stock market, except to the extent that such a market undermines the long-term stability of prices for ordinary goods. But if the stock market collapses too quickly, the Fed should worry about a recession and react aggressively to cushion the fall.

Are traders right? Is Q.E. merely the sequel to the “Greenspan put”? It is certainly the case that today’s super-low interest rates encourage investors to pour funds into risky assets. The Fed probably would argue that it is the job of regulators to make sure that asset bubbles do not induce too much borrowing and an eventual debt crisis, though of course monetary policy has to be in the mix.

Given the sluggish recovery, Bernanke could have gone even further and argued that the Fed is the one who has it right. Other advanced-economy monetary authorities, such as the European Central Bank, might be over-reacting to short term inflation volatility.

However, perhaps not wanting to cause problems for his foreign counterparts, Bernanke took a more cautious approach, merely defending the Fed’s policy as the right choice for America.

In defending the Fed’s policy, Bernanke had to be careful not to say anything that might overly alarm investors. Indeed, there is already reason enough for them to be nervous: After all, the Fed’s epic easing of financial conditions must eventually be followed by exceptionally painful tightening. Will the economy be ready when the time comes?

Explaining the inevitable shift to tightening could prove a far greater challenge than explaining the exceptional accommodation of quantitative easing.

The Fed must always remember that no matter how calm and rational its analysis may be, it is dealing with markets that can be anything but calm and rational. Precisely because so much emotion has been invested in Q.E., the psychological effects of returning to normalcy are going to be perilous and unpredictable.

Kenneth Rogoff is professor of economics and public policy at Harvard University, and was formerly chief economist at the IMF. © 2011 Project Syndicate