In his highly anticipated speech this morning in Jackson Hole, Wyoming, Federal Reserve Chairman Ben Bernanke justified the Fed’s use of nontraditional monetary policy while acknowledging that there were potential risks. The chairman admitted that both the benefits and the costs of nontraditional monetary policies are uncertain. Therefore, the hurdle for using nontraditional policies should by higher. Labor market conditions provide the key metrics for setting that hurdle. Bernanke stated that the current stagnation of the labor market is a grave concern and that stagnation is caused by cyclical rather than structural changes in economic activity. This rationale paves the way for additional nontraditional policy actions which may include additional forward guidance on the expected level of the fed funds rate as well as additional large-scale asset purchases (quantitative easing). According to Bernanke, other headwinds restricting U.S. economic growth include U.S. fiscal policy (the so-called Fiscal Cliff), and financial strains resulting from uncertainty about developments in Europe. Reading between the lines of the chairman’s speech, it appears that the key to the September 12-13 FOMC meeting will be the August labor market data, due out on September 7. A stagnant or increasing unemployment rate satisfies the chairman’s hurdle for additional nontraditional monetary policy. A declining unemployment rate accompanied by moderate job creation may keep the Fed on hold until October. I expect to see weak-to-moderate job creation, in the range of 130,000 net payroll jobs in August, and an unemployment rate stuck at 8.3 percent. This would clear the hurdle for more nontraditional monetary policy. At the least, we could see revised forward guidance on the fed funds rate, perhaps including a pledge to keep it near zero through mid-2015. Beyond that, there is the possibility of another round of quantitative easing, perhaps focused on long-term Treasury bonds and mortgage-backed securities, which could potentially be coordinated with a similar move by the European Central Bank. Chairman Bernanke’s analysis of nontraditional monetary policy is less critical than that of a recent working paper issued by the Federal Reserve Bank of Dallas, titled “Ultra Easy Monetary Policy and the law of Unintended Consequences,” by William White. In that paper, White argues for more restraint on the part of the FOMC, putting greater emphasis on the costs of nontraditional monetary policy. Those costs include an array of unintended consequences that can weaken both aggregate supply and demand.
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