Bernanke Takes The Bull By Its Horns

Julia Coronado - BNP Paibas

In a speech before at a conference of central bankers in Frankfurt Friday, Chairman Bernanke gave a forceful defense of the Fed’s move to ease monetary policy through additional Treasury purchases. In addition he took direct aim at China and other countries with undervalued currencies as a driver of imbalanced recoveries across the globe. He said that “persistently high unemployment, through its adverse effects on household income and confidence, could threaten the strength and sustainability of the recovery.” He cited the disinflationary pressures created by elevated unemployment and suggested that “with shorter-term nominal interest rates close to zero, declines in actual and expected inflation imply both higher realized and expected real interest rates, creating further drags on growth.” He said that “In light of the significant risks to the economic recovery…the FOMC

decided that additional policy support was warranted” and that “insufficiently supportive policies in the advanced

economies could undermine the recovery not only in those economies, but for the world as a whole.” He cited the previous success of securities purchases in stabilizing the economy and supporting the recovery and indicated he expects a similar performance from the current round, noting that “financial conditions eased notably in anticipation of the Federal Reserve’s policy announcement.” He stressed that the Fed “remains unwaveringly committed to price stability and does not seek inflation above the level of 2 percent or a bit less that most FOMC participants sees consistent with the Federal Reserve’s mandate” and that the Fed has “worked hard to ensure that it will not have any problem exiting from this program at the appropriate time.”

The Chairman then went on to directly address international critics that have accused the Fed of trying to

manipulate the value of the dollar and destabilize the global currency system with its policies. He said “fully aware of the important role that the dollar plays in the international monetary and financial system, the Committee believes that the best way to continue to deliver the strong economic fundamentals that underpin the value of the dollar, as well as to support the global recovery, is through policies that lead to a resumption of robust growth in a context of price stability in the United States.” He then took direct aim at the undervaluation of many emerging market currencies, China in particular. He acknowledged that “some officials in emerging market economies and elsewhere have argued that accommodative monetary policies in the advanced economies, especially the United States, have been producing negative spillover effects on their economies...[by] inducing excessive capital inflows…[that] put unwelcome upward pressure on emerging market currencies and threaten to create asset price bubbles.” However he said that “an important driver of the rapid capital inflows to some emerging markets is incomplete adjustment of exchange rates in those economies, which leads investors to anticipate additional returns arising from expected exchange rate appreciation.” He showed a chart that plotted real exchange rate appreciation against foreign exchange accumulation and noted that “the economies that have most heavily intervened in foreign exchange markets have succeeded in limiting the appreciation of their currencies.” In the Chart, the most aggressive and successful at maintaining undervalued currencies were China, Taiwan and Hong Kong. He noted that global reserves were increasing rapidly as a result of these activities and China accounted for “about half” of the total accumulation. It is a bold step for Chairman Bernanke to be so explicit and clearly signals that not only is the recent decline in the dollar a welcome result of the expansionary policy, but it should go further still.

He noted that maintaining undervalued currencies has been a strategy for export-led growth and development but he cited three key drawbacks to the strategy. First, he said that currency undervaluation “inhibits macroeconomic adjustments” resulting in a “two-speed” global recovery which risks being “resolved in favor of slow growth for everyone if the recovery in the advanced economies falls short. Likewise, large and persistent imbalances in current accounts represent a growing financial and economic risk.” Second, currency undervaluation by some counties imposes a greater burden on countries that allow “substantial flexibility in their exchange rates.” In his chart these countries included India, Chile, Brazil and Indonesia. Third, currency undervaluation leads to growing risks to the domestic economies of those engaged in these activities through “excessive or volatile capital inflows” and the lack of progress in domestic living standards. He noted that “the international monetary system has a structural flaw; it lacks a mechanism, market based or otherwise, to induce needed adjustments by surplus countries.” He said “it would be desirable for the global community, over time, to devise an international monetary system that more consistently aligns the interests of individual countries with the interests of the global economy as a whole.