Bernanke's Dilemma

Abstract

At what point in the tepid recovery from the global financial crisis should the Fed take a major step in normalizing U.S. monetary policy by greatly reducing its holdings of U.S. Treasury bonds? Federal Reserve Board Chairman Ben Bernanke faced this question in summer 2013, even as he was concerned that the U.S. economy was still on a weak footing. Suitable for both core and elective MBA courses in global financial markets and international finance, this case examines the risks associated with a policy some would consider monetizing the budget deficit. Students consider the factors behind past, current, and prospective levels of U.S. long-term interest rates. Excerpt UVA-GEM-0111 Rev. Jul. 29, 2013 Bernanke's dilemma “[N]o central bank anywhere on the planet…has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank—not, at least, the Federal Reserve—has ever been on this cruise before.” Ben Bernanke was entering the final year of a difficult eight-year term as chairman of the Board of Governors of the U.S. Federal Reserve (the Fed). Earlier in his career, as an economics professor at Princeton, he had written influential research papers advocating a policy of inflation targeting. Inflation targeting, in its simplest form, is rather mechanical. If inflation is forecasted to be above some predetermined range, tighten monetary policy; if inflation is projected to be lower than the stated range, loosen it. The Fed's dual mandate seemed to preclude a pure inflation target—the mandate dictated that it also focus on employment—but the thinking when he took over in early 2006 was that perhaps the Bernanke Fed would be a de facto inflation targeter. Alas, at this point, in July 2013, a relatively mechanical inflation targeting policy was only a dream. Bernanke would go down in history as the chairman who brought the Fed into uncharted waters (for it, at least). His initial response to the global financial crisis (GFC) was to lower the federal funds (fed funds) rate to about 0% and implement an almost unfathomable campaign of new facilities to free up frozen credit markets. In November 2008, when the economy was still very weak and financial markets were reeling, the Fed began its attempt to directly influence long-term interest rates by making massive purchases of U.S. Treasury bonds, the first of the so-called quantative easing (QE) measures. Those policies raised eyebrows but were largely seen as necessary to keep the U.S. (and world) economy from sliding into another Great Depression. . . .