August 23rd, 2011 | By Nick Sargen
This issue has resurfaced in the wake of recent developments, including revised forecasts of economists calling for little or no U.S. growth, not only for the second half of this year but also into 2012. Even more surprising was the Fed’s unprecedented statement that it intended to keep short-term interest rates near zero through the middle of 2013. These developments and worries about Europe have sent treasury yields plummeting to all-time lows. For a growing number of commentators, this has raised the specter that the U.S. economy is looking more like Japan’s did in the 1990s.
To gain perspective on this issue, I have re-read a famous speech Ben Bernanke delivered in November of 2002, when he was a Governor of the Federal Reserve. In the speech, Bernanke articulated how deflation could be combated, and he cited two reasons about why the U.S. was different from Japan. (See “Deflation: Making Sure ‘It’ Doesn’t Happen Here”) First, he did not believe the U.S. faced the massive financial problems in the banking and corporate sectors and a large overhang of government debt that Japan did. Second, he argued that political constraints, rather than a lack of policy instruments, explain why deflation persisted in Japan.
Bernanke concluded his remarks by saying that “policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.” The policy tools he discussed turned out to be ones he has pursued as Fed Chairman in the aftermath of the 2008-09 financial crisis. They included reliance on quantitative easing (or massive purchases of securities) and procedures designed to lower rates further out along the treasury yield curve.
In light of all that has happened since then, I would offer the following assessment of the role U.S. monetary policy has played since the onset of the financial crisis:
First, the initial round of quantitative easing, which was geared to bolster the inter-bank and money markets, as well as illiquid mortgage-backed securities, achieved its objective: namely, it averted a financial meltdown and thereby helped prevent a severe recession from becoming a depression. It also laid the groundwork for a modest recovery by driving real (or inflation-adjusted) interest rates negative.
That said, the effects of second round of quantitative easing (QE2), which was launched one year ago, are less apparent on the economy. Consequently, some observers believe it was ineffective. It should be recalled, however, that the primary purpose of QE2 was to buy protection against deflation. In this respect, it has affected inflation expectations, by contributing to a weaker dollar and higher commodity prices.
While some observers have called for the Fed to embark on a new round of easing, the case is less compelling today, because core inflation is within the Fed’s “comfort zone” of 1%-2%. Rather, the focus is shifting to U.S. fiscal policy, which is about to turn restrictive amid worries about long-term budget prospects. In this regard, there is a danger that U.S. environment today is becoming as politicized as Japan’s was in the 1990s, and policymakers could be constrained from responding to economic weakness.
Nonetheless, this does not necessarily mean the U.S. is headed for a “lost decade,” because the response of the private sector has been very different from Japan’s experience. In Japan’s case, businesses continued to hire redundant workers and to add to excess capacity in the aftermath of the bursting of the stock market and real estate bubbles. As a result, Japan did not experience a severe recession, but recovery was also very shallow.
By comparison, U.S. businesses responded to the financial crisis by shedding workers aggressively, while cutting back on capital spending and inventories. While this contributed to a severe economic downturn, U.S. businesses profits are now at all time highs and their balance sheets are very strong.
A second difference is the response of financial institutions in the two countries. In Japan’s case, banks were slow to write-off bad loans, and the financial system became clogged, with banks reluctant to extend new loans. By comparison, the write-off of securities in the U.S. financial crisis was very rapid due to mark-to-market accounting treatment, and banks replenished their capital with the assistance of government support. While U.S. banks were slow to extend new loans in 2009-2010, consumer and industrial loans have turned positive this year.
In sum, the rapid adjustments of U.S. businesses and financial institutions are the principal factors that lessen the risk of a lost decade. That said, the U.S. economy could be very weak for the next couple of years. With the Fed on hold during that stretch, we are positioning bond portfolios for an extended period of low interest-rates.