After pumping more than a trillion dollars into the financial system, forcing interest to near zero and buying back hundreds of billions of dollars of bad mortgage bonds, the Federal Reserve has adopted a new monetary policy.
Call it "wait and see."
Fed Chairman Ben Bernanke was on Capitol Hill Wednesday testifying on the central bank's latest strategies for getting the economy back on a stronger footing. The hearing comes a day after minutes of the Fed's latest Open Market Committee meeting in June showed the group divided over what to do next.
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Some members want to consider resuming the pump-priming policy of buying up bonds. The majority, including Bernanke, argue that the recent "soft patch" in growth resulted from a temporary surge in oil prices and the supply bottlenecks from the Japanese earthquake.Story: Bernanke: Fed will help if economic weakness persists
"Once the temporary shocks that have been holding down economic activity pass, we expect to see again the effects of (recent Fed policy) reflected in stronger economic activity and job creation," Bernanke told the House Financial Services Committee.
After a convincing pickup in growth last year, the economy slowed sharply in the first quarter and has been limping along since. First quarter gross domestic product edged up just 1.9 percent. The latest monthly data, especially the surprising collapse in job growth in May and June, have raised concerns that the recovery may be stalling out.
For now, central bankers don't see that happening. Bernanke said that while they've trimmed their growth forecasts, Fed forecasters believe growth will rise in the second half of the year to between 2.7 percent and 2.9 percent for the full year. The Fed forecast sees the economy gathering more steam next year, expanding at a rate of 3.3 to 3.7 percent.
So until the data from the second half starts rolling in, Bernanke and most of his colleagues think the best course is to do nothing.
"The Fed has thrown the kitchen sink at the markets with massive liquidity," said Paul Ballew, a former Federal Reserve economist and now chief economist at Nationwide. "So I expect in the second half they stay on the sidelines, they try get a read for the overall health of the economy and then make their decisions from there."
Though the Fed is on hold for now, Bernanke was quick to note that the central bank stands ready to take action if there are new shocks to the global economy or the financial system. Investors were cheered by just a mention that central bank might consider showering more money on the financial markets. Stocks and bonds rallied shortly after Bernanke's prepared testimony was released.
There are plenty of potential sources for shocks that could throw the economy off kilter. The ongoing political fracas over the federal budget, for one, has the bond market on edge. Congressional dithering over raising the debt ceiling has raised the threat of a default on U.S. Treasury debt.
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The spreading debt crisis in Europe, for another, threatens to spark a banking panic that could put pressure on U.S. banks.Story: Debt ceiling talks entering uncharted waters
Bernanke said the U.S. would continue to pay interest on its debt even if Congress failed to extend the debt ceiling by Aug. 2, when the government is scheduled to exceed its borrowing authority.
"The assumption is that as long as possible, the Treasury would want to try to make payments on the principal and interest to the government debt, because failure to do that would certainly throw the financial system into enormous disarray and have major impacts on the global economy," Bernanke said.
Nevertheless, any of these shocks could produce the Fed's worst nightmare: a surge in market-driven interest rates that would severely test the central bank's ability to keep interest rates low. In his testimony, Bernanke reminded the committee of the importance of holding rates down.
"We know from many decades of experience with monetary policy that when the economy is operating below its potential, easier financial conditions tend to promote more rapid economic growth," he said.
But the Fed doesn't have many tools left to hold down rates if bond investors get spooked and demand higher interest payment to offset the risk of not getting their money back. Bernanke assured the committee that the Fed has "several options," and cited two. One would be to be more explicit about its plans to keep rates low for a very long time. The other would be to scale back the interest payments to banks that store cash in the Fed's accounts.
"A lot of the options he put on the table were effectively worthless," said Drew Matus, a senior economist at UBS Investment Research. "So I think Bernanke really is just hoping for the best."
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