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Federal Reserve Chairman Ben Bernanke wrapped up two days of testimony with a hearing before the Senate Committee on Banking, Housing, and Urban Affairs today, after a House committee hearing yesterday. While the prepared remarks before the House and Senate were the same, the message conveyed by Bernanke on both days was very different.

After yesterday’s testimony, markets came away with the message that QE3 was around the corner, leading to a rally in equities and a drop in the dollar. However, clearly surprised by this interpretation of what were intended to be neutral remarks, Bernanke today stressed that the FOMC was “not prepared at this point to take further action.” He reiterated that inflation now is “higher” and “closer” to the central bank’s informal target than was the case in August 2010 making QE3 unnecessary at this time. This was the right message to send the markets for two reasons.  

First, monetary policy has, at least temporarily, reached its limit. An additional round of quantitative easing at this time puts the United States at risk of stagflation–higher inflation without a sustained increase in real economic variables like growth and employment. The latest FOMC meeting minutes from June highlighted the Fed’s predicament. The Fed lowered the growth forecast range for 2011 from the 3.4-3.9 percent range in February to a 2.7-2.9 percent range and acknowledged an increase in the core PCE inflation forecast from 1.0-1.3 percent to 1.5-1.8 percent. Therefore, the probability of the Fed using further monetary easing to stimulate growth is very low unless deflation risks reemerge.

Second, even if QE3 is an option in the future, following a sustained period of higher growth and lower inflation that allays stagflation fears, the Fed should not give Congress a free lifeline with the current debt ceiling debate. The knowledge that a monetary stimulus package is off the table will prod legislators to take action and get our fiscal house in order. 

Sending different signals to the market about QE3 on consecutive days was a poor job at communicating by the Fed president, but he at least ended on the right note.

President Obama will lay out his plan to rein in the nation’s rising deficit in a speech this afternoon. While statements from the White House suggest that he will support GOP-favored steps such as reducing Medicare and Medicaid costs, his call to raise taxes on the wealthy is unlikely to be supported by the Right.

The Republicans have strong academic research backing their stance. Analysis of historical fiscal consolidations (that is, policies intended to reduce deficits and the accumulation of debt) of select OECD countries from 1970 to 2007 by AEI’s Andrew Biggs, Kevin Hassett, and Matthew Jensen show that successful consolidations consisted of 85 percent spending cuts. By contrast, the typical unsuccessful fiscal consolidation consisted of only 47 percent spending cuts and 53 percent tax increases. Additionally, the AEI analysis shows that the negative Keynesian effects of reduced spending can be offset if a large and credible fiscal consolidation generates confidence that more disruptive steps have been avoided down the road and actually lead to the creation of jobs and a boost in economic growth.

One of the countries that served as a model of getting fiscal consolidation right was Sweden in the 1990s. It was able to reduce deficits from 10 percent in 1994 to 2 percent in 1997. The cornerstones of their economic policies of the 1990s are still in place and helped Sweden get through the financial crisis without ruining public finances. AEI will host a panel on April 18 with Anders Borg, Sweden’s minister for Finance. Borg will offer insight into the lessons that the United States can learn from the Swedish model, and be joined by panelists Johnny Munkhammar, Carmen Reinhart, and Vincent Reinhart.

Rohan Poojara is a research assistant at AEI.

At an event in Washington, D.C., this morning, the Financial Crisis Inquiry Commission (FCIC) released its report on the causes of the financial and economic crisis of 2007-2009, noting that the entire episode was avoidable. The event was marked by the absence of the four Republican commissioners, who instead submitted two separate dissents to the report. Criminal activities and possible prosecutions were a theme that the media pressed the commissioners on during the Q&A, especially after Chairman Phil Angelides noted that the FCIC had referred certain individuals to the attorney general or state authorities for investigation. However, the commissioners were unwilling to elaborate further and we will have to wait and see what, if any, prosecutions or policy reforms result from 18 months of the FCIC’s work.

Image by dflorian1980.

Today the Federal Reserve Open Market Committee (FOMC) released the transcripts from its 2005 meetings, following its usual schedule of release with a five-year lag. You can read them here. Expect these documents to be thoroughly scrutinized in the coming weeks because the FOMC had been discussing the overheated housing market through most of 2005 and even spent a full day on the topic in the June meeting.