Bernanke says the Fed has the tools it needs to fight the next recession

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(Bloomberg) – Former Fed chairman Ben Bernanke made a "relatively optimistic" assessment of the Fed's ability to deal with the next recession.

While the Fed has limited scope for short-term rate cuts because they are already so low, Bernanke argued that quantitative easing and forward steering could offer enough additional clout to counter a future economic downturn.

"The new policy tools are effective," Bernanke said in a blog post summarizing his speech at the American Economic Association's annual meeting on Saturday. "Quantitative easing and forecasts can mean about 3 additional percentage points of short-term interest rate cuts."

Bernanke said the Fed should also consider adopting some of the tools used by other central banks, including controlling the yield curve over two years and financing loan programs. He advised the Fed to rule out the possibility of pushing short-term interest rates below zero – something that many current policy makers have come very close to in their public statements.

Regardless of how the Fed works to address future recessions, Bernanke, who is now a Distinguished Fellow at the Brookings Institution in Washington, said that yields will be zero or below for an extended period of time.

Vigilance is essential

This can endanger financial stability. "The monetary easing in some cases increases the risk appetite of investors and lenders," said Bernanke. "Vigilance and proper policies, including macroprudential and regulatory policies, are essential."

According to its estimate of the impact of QE and future forecasts, the Fed expects to promise not to raise interest rates from zero until inflation reaches 2%. While policymakers are considering changes in their approach to achieving their inflation target, it is not clear whether they would go that far.

Bernanke said his judgment that monetary policy will be able to fight the next recession is also based on a crucial hypothesis: the neutral level of short-term interest rates, which neither stimulates nor restricts economic growth, is between 2% and 3% ,

If the equilibrium rate is far below, as some Fed surveys have suggested, QE and forward guidance are insufficient to prevent a downturn. "In this case, other measures to increase political scope, including raising the inflation target, may be needed," he said.

Fiscal policy may also have to play a more central role in combating contraction – a possibility the government should now prepare for, Bernanke said.

Central banks in Europe and Japan face even greater difficulties, mainly because inflation expectations there have fallen too far. "Tax and monetary policies may be required in these countries to increase inflation expectations," he said. "If possible, monetary policy, supplemented by new policy instruments, should regain much of its effectiveness."

Bernanke said monetary policy had almost closed since the days of late Fed chairman Paul Volcker. Now the problem is not that inflation is too high, but the risk that it is too low.

"Low inflation can be dangerous," Bernanke wrote on his blog. "In line with its stated" symmetrical "inflation targets, the Federal Reserve and other central banks should fight inflation too low, at least as vigorously as they fight inflation too high."

Contact the reporter about this story: Rich Miller in Washington at rmiller28@bloomberg.net

Contact the editors responsible for this story: Margaret Collins at mcollins45@bloomberg.net, Alister Bull, Ros Krasny

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