Bernanke: Federal Reserve's Tools Can't Offset Fiscal Tightening; U.S. Hits Debt Ceiling In Early 2013 (QE4 Possible)

With the fiscal cliff (automatic tax hikes and spending cuts) arriving on January 1, 2013, Federal Reserve Chairman Ben Bernanke, in a speech given at the Economic Club of New York on November 20, 2012 (1:12 in the video), wanted to remind everyone that monetary policy can't offset fiscal tightening. He said, "I don't think the Fed has the tools to offset that. And that's why it is important for Congress to address these fiscal issues soon and in a bipartisan way."

Source: (full speech video here)

Here are quotes from Ben Bernanke's speech transcript:

"Upcoming Fiscal Challenges
source: Bloomberg TV
What are these looming challenges? First, the Congress and the Administration will need to protect the economy from the full brunt of the severe fiscal tightening at the beginning of next year that is built into current law--the so-called fiscal cliff. The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery--indeed, by the reckoning of the Congressional Budget Office (CBO) and that of many outside observers, a fiscal shock of that size would send the economy toppling back into recession. Second, early in the new year it will be necessary to approve an increase in the federal debt limit to avoid any possibility of a catastrophic default on the nation's Treasury securities and other obligations. As you will recall, the threat of default in the summer of 2011 fueled economic uncertainty and badly damaged confidence, even though an agreement ultimately was reached. A failure to reach a timely agreement this time around could impose even heavier economic and financial costs.

As fiscal policymakers face these critical decisions, they should keep two objectives in mind. First, as I think is widely appreciated by now, the federal budget is on an unsustainable path. The budget deficit, which peaked at about 10 percent of GDP in 2009 and now stands at about 7 percent of GDP, is expected to narrow further in the coming years as the economy continues to recover. However, the CBO projects that, under a plausible set of policy assumptions, the budget deficit would still be greater than 4 percent of GDP in 2018, assuming the economy has returned to its potential by then. Moreover, under the CBO projection, the deficit and the ratio of federal debt to GDP would subsequently return to an upward trend.9 Of course, we should all understand that long-term projections of ever-increasing deficits will never actually come to pass, because the willingness of lenders to continue to fund the government can only be sustained by responsible fiscal plans and actions. A credible framework to set federal fiscal policy on a stable path--for example, one on which the ratio of federal debt to GDP eventually stabilizes or declines--is thus urgently needed to ensure longer-term economic growth and stability.

Even as fiscal policymakers address the urgent issue of longer-run fiscal sustainability, they should not ignore a second key objective: to avoid unnecessarily adding to the headwinds that are already holding back the economic recovery. Fortunately, the two objectives are fully compatible and mutually reinforcing. Preventing a sudden and severe contraction in fiscal policy early next year will support the transition of the economy back to full employment; a stronger economy will in turn reduce the deficit and contribute to achieving long-term fiscal sustainability. At the same time, a credible plan to put the federal budget on a path that will be sustainable in the long run could help keep longer-term interest rates low and boost household and business confidence, thereby supporting economic growth today.

Coming together to find fiscal solutions will not be easy, but the stakes are high. Uncertainty about how the fiscal cliff, the raising of the debt limit, and the longer-term budget situation will be addressed appears already to be affecting private spending and investment decisions and may be contributing to an increased sense of caution in financial markets, with adverse effects on the economy. Continuing to push off difficult policy choices will only prolong and intensify these uncertainties. Moreover, while the details of whatever agreement is reached to resolve the fiscal cliff are important, the economic confidence of both market participants and the general public likely will also be influenced by the extent to which our political system proves able to deliver a reasonable solution with a minimum of uncertainty and delay. Finding long-term solutions that can win sufficient political support to be enacted may take some time, but meaningful progress toward this end can be achieved now if policymakers are willing to think creatively and work together constructively.

Monetary Policy
Let me now turn briefly to monetary policy.

Monetary policy can do little to reverse the effects that the financial crisis may have had on the economy's productive potential. However, it has been able to provide an important offset to the headwinds that have slowed the cyclical recovery. As you know, the Federal Reserve took strong easing measures during the financial crisis and recession, cutting its target for the federal funds rate--the traditional tool of monetary policy--to nearly zero by the end of 2008. Since that time, we have provided additional accommodation through two nontraditional policy tools aimed at putting downward pressure on longer-term interest rates: asset purchases that reduce the supply of longer-term securities outstanding in the market, and communication about the future path of monetary policy.

Most recently, after the September FOMC meeting, we announced that the Federal Reserve would purchase additional agency mortgage-backed securities (MBS) and continue with the program to extend the maturity of our Treasury holdings.10 These additional asset purchases should put downward pressure on longer-term interest rates and make broader financial conditions more accommodative.11 Moreover, our purchases of MBS, by bringing down mortgage rates, provide support directly to housing and thereby help mitigate some of the headwinds facing that sector. In announcing this decision, we also indicated that we would continue purchasing MBS, undertake additional purchases of longer-term securities, and employ our other policy tools until we judge that the outlook for the labor market has improved substantially in a context of price stability.

Although it is still too early to assess the full effects of our most recent policy actions, yields on corporate bonds and agency MBS have fallen significantly, on balance, since the FOMC's announcement. More generally, research suggests that our previous asset purchases have eased overall financial conditions and provided meaningful support to the economic recovery in recent years.12

In addition to announcing new purchases of MBS, at our September meeting we extended our guidance for how long we expect that exceptionally low levels for the federal funds rate will likely be warranted at least through the middle of 2015. By pushing the expected period of low rates further into the future, we are not saying that we expect the economy to remain weak until mid-2015; rather, we expect--as we indicated in our September statement--that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.13 In other words, we will want to be sure that the recovery is established before we begin to normalize policy. We hope that such assurances will reduce uncertainty and increase confidence among households and businesses, thereby providing additional support for economic growth and job creation.

In sum, the U.S. economy continues to be hampered by the lingering effects of the financial crisis on its productive potential and by a number of headwinds that have hindered the normal cyclical adjustment of the economy. The Federal Reserve is doing its part by providing accommodative monetary policy to promote a stronger economic recovery in a context of price stability. As I have said before, however, while monetary policy can help support the economic recovery, it is by no means a panacea for our economic ills. Currently, uncertainties about the situation in Europe and especially about the prospects for federal fiscal policy seem to be weighing on the spending decisions of households and businesses as well as on financial conditions. Such uncertainties will only be increased by discord and delay. In contrast, cooperation and creativity to deliver fiscal clarity--in particular, a plan for resolving the nation's longer-term budgetary issues without harming the recovery--could help make the new year a very good one for the American economy."

Chairman Bernanke also warned about the fiscal cliff at his FOMC press conference on September 13, 2012 (full transcript).

"MICHELLE FLEURY. You said that you can’t cure all ills, that you haven’t got strong enough tools to deal with the unemployment problem. I was curious to know what policy actions you’d like to see outside the Fed to try and address this. And, secondly, also on the “fiscal cliff,” the expected spending cuts and tax increases, how concerned are you about that? And what ammunition do you have to deal with that, if that becomes a problem?

CHAIRMAN BERNANKE. Well there’s, again, a range of areas where actions could be taken, and I can’t really prescribe all those possible responses. I would focus, I think, on the fiscal side. We currently have the so-called fiscal cliff. If no action is taken, there’s going to be a very substantial increase in taxes and cut in spending on January 1 of the coming year. The CBO has suggested that if that’s allowed to take place, that it would cause unemployment to begin to rise, and it might throw the economy back into recession. So I think one very basic thing that could be done to help address the recovery—the weakness of the recovery and the need for more employment—would be to address the fiscal cliff while simultaneously addressing longer-term fiscal sustainability issues which remain, of course, very serious. So that’s one area where there is a lot of potential benefit. If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency. So I think it’s really important for the fiscal policymakers to, you know, work together and try to find a solution for that."

But, just in case the Fed gets desperate, the FOMC Minutes of the October 23-24 meeting mentioned that QE4 "would likely be appropriate" when the "maturity extension program" (aka Operation Twist) ends at the end of the year.

"Participants also discussed the efficacy and potential costs of the Committee's asset purchases. A number of participants offered the assessment that the Committee's policy actions, to date, had been effective in making financial conditions more accommodative and that lower interest rates were providing support to aggregate spending, most notably in areas such as housing, autos, and other consumer durables. In particular, some pointed out that the favorable developments in mortgage markets over the intermeeting period suggested that the MBS purchases were likely to reinforce the nascent recovery in the housing market. Several added that, based on the experience with earlier asset purchases, the broader effects on economic activity from more-accommodative financial conditions were likely to accrue over time. Looking ahead, a number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program in order to achieve a substantial improvement in the labor market. In that regard, a couple of participants noted the likely usefulness of clarifying the range of indicators that would be evaluated in assessing the outlook for the labor market. Participants generally agreed that in determining the appropriate size, pace, and composition of further purchases, they would need to carefully assess the efficacy of asset purchases in fostering stronger economic activity and consider the potential risks and costs of such purchases. Several participants questioned the effectiveness of the current purchases or whether a continuation of them would be warranted if the recent moderate pace of economic recovery were sustained."

At the moment, some investors (probably those in the highest tax bracket, see Obama's tax plan) are realizing profits before the Bush tax cuts expire. We'll see what kind of deal the Republicans and Democrats make on taxes and spending (if any). And the next debt ceiling debacle should be fun as well.