Sitting in his large office suite on the top floor of the Federal Reserve Building on 20th Street and Constitution Avenue, Chairman Bernanke was dreading the morning of June 1.
Coming into the office in his armored Chevy Suburban, he went over his personal economic outlook. At the structural level, he had no doubt that the U.S. economy was mending itself. His gut feeling and his staff’s numbers told him as much. Prodded on by the policy actions and the economic reality, the U.S. economy was dealing with its two biggest issues: housing-related leverage and a bloated manufacturing cost structure. But the problem, as he well knew, is that you can’t eat “structural improvement.” At some point, the cyclical part has to deliver. Otherwise, for a large economy the size of the United States, flying this close to the ground is full of all manner of risk. A cyclical slowdown can very easily snuff out structural improvements and take the economy back to the path of deflationary abyss.
That was the scenario he was dreading at the moment, and the cursed June employment report was upon him. Even after a downward revision, the 1Q12 GDP growth rate was respectable and the economic momentum for 2Q12 and 2H12 was enough — as long as we could get through the summer in one piece, he surmised. While the U.S. economy was dealing with its own issues, the Europeans had perfected the art of shooting themselves and the rest of the world’s economies in their respective feet.
On that front, Dr. Bernanke, who usually was not prone to cursing, let a couple of choice ones fly through his pursed lips at European policymakers. “For the love of God, find a way of dealing with your policy mess and help yourself. At least do something to avoid pulling the world down. Because they can’t agree on anything, Europe and the world are at the doorstep of deflation again. Had they looked at the German breakeven rates recently? They are in basis points, for Pete’s sake.” Enough venting, he had his own issues to deal with. The employment report was due any minute. (Contrary to popular belief, the Fed did not get an advance look at these reports. Using their models, they could certainly guess, but they never know for sure.)
At 8:30 a.m. sharp, the bad news overwhelmed him. Not only was the headline number back to the levels of last summer, the entire series of numbers were all bad. And they were decidedly worse than what the markets, in the throes of European debacle, had been expecting. The color on his Bloomberg screen went all red. Before the day was out, he had no doubt, U.S. 10-year yields would be at their lowest levels ever and the S&P 500 would be testing the lows of the year. Pretty soon the phone calls from his fellow FOMC members would be flooding in. His best guess was that he had, at most, 30 minutes to formulate a policy response to formulate a consensus that he could sell to both the hawks and the doves on the committee.
On the inflationary front, he saw nothing but good news: Wages continued to drift lower and the headline Personal Consumption Expenditure was dipping below 2%. In other words, if inflation were a concern, as it most certainly was for the hawks, there was headroom to allow for some policy action.
On the other hand, from a growth standpoint, it was not just today’s employment number that was problematic. It has been bad for a few weeks now: Real spending, consumer confidence, private investment and manufacturing surveys were all utterly uninspiring. While none of them foretold a double-dip, they certainly weren’t at par with the FOMC’s growth projections. And, therefore, based on what the chairman had already articulated to the markets, the case for policy action was building. The key question, then, was not whether anything should be done, but if something needed to be done by the June FOMC meeting. On that front, he was not so sure. Just as importantly, while he had no doubt that the Eric Rosengren camp of the Fed would be supportive, and the Richard Fishers of the committee could never be convinced, he could not be sure if he could carry the centrists, like Sandra Pianalto.
The situation was even more complicated by the fact that rates had already rallied almost 50 basis points in May. He was not sure if getting the 10-year rate to 1.25% would help a great deal. And while buying agency mortgages to expand the Fed’s balance sheet would certainly help the housing market, he was not sure if the housing market needed that dollop of help. Besides, agency mortgages had rallied step for step with treasuries just on this expectation of help, and in that case, the market was preemptively easing without the Fed having to do anything. In other words, communications as a policy tool was working anyway, so what was the hurry?
He also recognized that in a politically charged election year, he had to tread lightly. If he initiated some policy response quickly and the economy turned around before that stimulus took effect, his ability to implement future policy actions when the economy really needed help would be somewhat limited, especially as the centrists would move toward the hawks. In other words, he was running out of bullets and he had to be damn sure of the need to shoot before he let a round go to waste.
For now, then, he and the committee had to stand pat and ironically wait for the outlook to worsen. And while he was sensitive to another Paul Krugman critique of the Fed-abdicating-its-responsibility kind, he had bigger and more important issues to deal with. No, the stimulus would have to wait until the end of the summer, if at all.
He picked up his phone and asked his secretary to call Vice Chair Janet Yellen. He would start with her.
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