Yesterday, Federal Reserve Chairman Ben Bernanke went before Senate to defend the Federal Reserves loose monetary policy. The Federal Reserve has engaged in “Quantitative Easing“, pumping “cheap money” (because the fed can borrow at basically 0% interest rates) into the economy to stimulate consumption and investment (and therefore reduce unemployment).

It is important for the Federal Reserve to partake in unconventional monetary policy. Usually, the Fed adjusts the interest rate to stimulate the economy in one direction or another (speed up a slumping economy or “cool down” an over-leveraged economy). But up against the “zero-bound“, the Fed has to use less conventional policy as the interest rate cannot be lowered below 0 to stimulate the economy.

“The Fed, which has amassed almost $3 trillion in Treasury and mortgage-backed securities to promote more borrowing and lending, is expanding those holdings by $85 billion a month until it sees clear improvement in the labor market. It plans to hold short-term interest rates near zero even longer, at least until the unemployment rate falls below 6.5 percent.”

The Fed is going to keep buying assets until the economy recovers, measured either by an unemployment rate below 6.5% or an inflation rate above 2%. As Inflation does not seem to be an issue currently (despite greatly increasing the supply of money in the economy, the USD has remained stable), the unemployment target seems to be the one that the Fed has focused on.

Exactly why the dollar has remained stable despite greatly increasing the monetary base is up for debate. The main argument is that since we are in a “liquidity crisis”, newly printed Fed money is simply taking the place of private sector money (which is being horded, see corporate profits). Therefore, even though the overall money supplied by the Fed has increased, the actual amount of dollars available to the market has not really increased.

Another explanation is that the USD is a global reserve currency (about 60% of global reserves are denominated in dollars). Not only does the US have stake in a strong dollar, but every other country does as well. Other countries have no interest in seeing their real reserve levels fall, and export-based economies have no interest in competing against a weaker dollar (which would make their imports cheaper and exports more expensive).

Therefore, a concerted global effort has kept the dollar stable despite the expansion of the monetary base. It is probably some combination of these two forces, along with other forces, that has kept the dollar stable. It should be heartening to see that the world still believes in the USD as a reserve currency post-Great Recession, a signal that the U.S. BOP and Federal deficits are sustainable (even if they are higher than politically popular).

Back to Bernanke being grilled by Senate: ” Mr. Corker [Senator, R, Tennessee] then accused Mr. Bernanke of insufficient concern about potential inflation, saying, ‘I don’t think there’s any question that you would be the biggest dove since World War II,’ using the term “dove” to denote a Fed official who is more concerned about unemployment than higher inflation.

Mr. Bernanke, clearly piqued, responded, ‘You call me a dove, but my inflation record is the best of any chairman in the postwar period.'”

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Mr. Bernanke is simply using the policy tools available to him that fit the current situation. If inflation was high and unemployment was low, his policies would be very irresponsible. But given the current economic climate, the Fed’s policies make sense. Mr. Bernanke understands the monetary system better than most; his academic work revolves mainly around monetary policy during and after the Great Depression (and liquidity crisis monetary policy). His knowledge of monetary policy in face of economic downturns is amongst the best in the world, and I for one believe having Bernanke as the chairman of the Fed has helped an otherwise weak economic recovery.

But might the Feds actions disrupt markets, causing asset bubbles instead of helping the real economy?

“Jeremy C. Stein, a member of the Fed’s Board of Governors, and some other Fed officials have expressed concern in recent months that low interest rates were encouraging excessive risk-taking by investors pursuing higher returns. Mr. Stein in a recent speech highlighted rising demand for junk bonds and certain kinds of real estate investments, and shifts in bank balance sheets, as areas of potential concern.

Mr. Bernanke said the Fed took these concerns “very seriously,” noting that the central bank had significantly expanded its efforts to monitor financial markets, as well as giving greater priority to financial regulation.”

One could argue that the Fed should be lending directly to business and individuals instead of using the financial system as an intermediary (after all, the financial system by-and-large got us into the mess we are currently in). There is a strong argument here, but this is simply not how the Fed functions (and drastically changing the policy of a major institution takes time, this cannot be a short term fix but perhaps an idea to consider going forward). This time around, it is up to strengthened financial regulation and adequate capital market taxation to ensure bubbles are not a byproduct of loose monetary policy (hopefully the sequester doesn’t hit the SEC too hard, or this job will prove even more difficult than it already is):

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Monetary policy cannot shoulder the whole load of this economic recovery, as Bernanke himself has stated. However, while fiscal policy remains deadlocked in partisan bickering (it seems that fiscal stimulus is unlikely anytime soon; it would be a victory if the U.S. could avoid fiscal austerity, a.k.a. the “sequester”). It is therefore even more important than usual to have loose monetary policy (both because of the reality of a global liquidity crisis and the inability to address economic concerns via fiscal policy).

Bernanke has made it part of his mission to make the Fed more transparent and engaged with the American people. This is a noble pursuit, as members of the Fed are not elected but instead appointed by elected officials. Monetary policy is inherently confusing, even to trained economists; the ability of Bernanke to make people feel more engaged in the process is a difficult proposition. I hope I am in some small way doing my part to help explain why the Fed is doing what it is doing. People have to forget any Econ 101 they may know or think they know (increasing the supple of something reduces it’s value), as we are currently in a very specific situation which calls for a very specific policy response.

It seems Bernanke’s words have had a calming effect on the global economy, as assurance that the Fed will not abandon it’s bond buying program drew a favorable response from markets. It would be nice if people agreed with what Bernanke was doing, but it is unrealistic to expect the lay-man to understand liquidity crisis monetary policy (even I, and people with more training than me, have trouble with it). It is a great benefit to the U.S. and global economy to have someone as knowledgeable as Ben Bernanke running the Federal Reserve.