Its not always wise to judge economic events by Wall Streets reaction. But there was a rational basis for the markets ecstatic response to Federal Reserve Chairman Ben Bernankes announcement Wednesday of a taper in central-bank asset purchases. Part of the Feds unconventional response to the Great Recession has been a massive expansion of its balance sheet, including the recent addition of about $85 billion per month in government or government-backed securities. The Feds decision to decelerate bond-buying, starting with a $10 billion reduction in January, is a sign of confidence that the economy is starting to stand on its own two feet. And markets are correct to agree, especially in light of Novembers better-than-expected job-creation report.
Equally important, the incipient taper signals the central banks belief that political risks to the economy are diminishing. The Fed embarked on its latest round of bond-buying a little more than a year ago, at a time when partisan disagreements on Capitol Hill were about to send the United States over a recessionary fiscal cliff. Bernanke tried to head that off via an easing of monetary policy. Now, by contrast, Republicans and Democrats have struck a budget deal that probably eliminates the threat of a government shutdown for two years and even boosts spending modestly in the short run. Bernanke alluded to this positive development Wednesday, adding that it will be good for confidence – thus affirming a central claim of the deals authors, Rep. Paul Ryan, R-Wis., and Sen. Patty Murray, D-Wash.
In other words, the Fed can back off because Congress has finally stepped up. Of course, that such intangibles could influence Bernanke shows that central banking is as much an art as it is a science. The U.S. economy is still too weak for most Americans comfort, for reasons – as Bernanke candidly concedes – that economists dont fully understand. The Feds purchases remain controversial, with even an internal Fed study suggesting that they have not necessarily yielded much additional growth. Bernanke, however, counters that monetary policy has been hampered by fiscal policy and structural changes, including a possible diminution in the economys long-term growth potential.
With inflation negligible and the job market weak, he had both the responsibility and the opportunity to innovate. As he emphasized Wednesday, the taper does not mean the Fed is tightening its overall policy but rather is shifting the emphasis to interest rates – which will stay near zero percent well after the jobless rate, currently at 7 percent, falls another half percentage point.
The policy announcement and accompanying news conference were probably the last big events of Bernankes eventful tenure. By his own admission, the Fed chairman was late to recognize the crisis that was already impending when he took office in 2006. Nevertheless, he responded to it creatively and forcefully, helping to limit the short-term damage; if he lost his cool or professionalism at any moment, we must have missed it. To his probable successor, Janet Yellen, he bequeaths an economy tentatively on the mend and a Fed in appropriately tentative retreat from its extraordinary interventions. He will be a hard act, but a good example, to follow.