Bernanke's dilemma

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As the Federal Reserve ponders its policy choices at the FOMC meeting today and tomorrow, Ben Bernanke is faced with the most difficult of policy dilemmas. Does the Fed start tapering off its program of buying US$85 billion a month in US Treasury bonds and in mortgage-backed securities and thereby risk slowing the fragile US economic recovery presently underway? Or does the Fed continue to expand its balance sheet at an unprecedented rate and thereby risk further inflating asset price bubbles and encouraging excessive risk taking, which would all too likely build up serious problems down the road?

Economic theory would seem to offer a way out of Mr. Bernanke's policy dilemma. As Professor Jan Tinbergen famously noted, if one has two policy targets to achieve, one necessarily must have two policy instruments in order to achieve those two targets. In the context of Mr. Bernanke's present dilemma, it would suggest that tinkering with quantitative easing alone will not allow the Fed simultaneously to support the economic recovery and to avoid asset price bubbles and excessive risk taking. Rather, if the Fed wishes to achieve both of those policy objectives, it must complement its policy of quantitative easing with vigorous use of its macro-prudential policy tools to limit the amount of risk financial institutions can take on their books.

If the past is prologue to the future, the Fed is likely to consider it to be of paramount importance not to risk any setback to the economic recovery. This will be especially the case since the Fed will consider that if the economic recovery were to falter and if the risk of deflation were to reappear it would be very difficult for the Fed to engage in yet another round of quantitative easing. It is also all too likely that the Fed will downplay the longer-term dangers of asset price bubbles and excessive risk taking and that it will do very little on the macro-prudential front to address those problems. Instead, the Fed is likely to continue unchanged its asset-buying program and indicate that it will only consider tapering off that program once the US economy shows greater strength than it has been showing of late.

As we should have learnt from previous episodes of asset price bubbles, such a policy course runs the very real risk that we will have a high price to pay down the road for neglecting the build-up of asset price bubbles and excessive risk taking. 

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About the Author

 

Desmond
Lachman
  • Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.
  • Phone: 202-862-5844
    Email: dlachman@aei.org
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    Name: Emma Bennett
    Phone: 202.862.5862
    Email: emma.bennett@aei.org

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