Bernanke’s legacy in successor Yellen’s hands

As the economic recovery in the developed world finally seems to be gathering sustainable momentum, one must not forget that it is the efforts and actions of economic policymakers, especially central bankers, which have led us out of the worst economic downturn since the Great Depression.

Leading the charge, and at times even being ahead of the curve, was Ben Bernanke, the outgoing chairman of the US Federal Reserve. Bernanke understood the severity of the financial crisis of 2007-08 and that it could not be fought with conventional economic ammunition. The government had to step in and restore credit and confidence in the financial system.

Without this interference, short-term credit channels would have frozen and the spillover effects to the real economy would have been catastrophic. The Quantitative Easing programmes of the Federal Reserve, Bank of England, European Central Bank and the Bank of Japan were initially an attempt to restore confidence in the financial markets and provide short-term liquidity.

As the financial systems of Japan and Europe were skewed towards being more bank-centric, the Bank of Japan and the European Central Bank focused on directly lending to banks. The Federal Reserve and the Bank of England on the other hand expanded their balance sheets (monetary base) by purchasing long-term bonds.

The fact that it is real interest rates that affect spending decisions meant that monetary policy actions by a central bank could stimulate the economy even if nominal interest rates hit a floor of zero. This was the underlying reason behind deploying quantitative easing by the Bernanke-led Federal Reserve.

Paul Volcker is credited with ending the hyper-inflationary environment in the US of the late 1970s. Alan Greenspan oversaw and helped guide the country through the crash of 1987, the savings and loans crisis of the early 1990s, the Long Term Capital Management default, the Asian financial crisis and the dot-com bubble burst. But Bernanke oversaw a systemic global crisis where the financial system was at the edge of a cliff.

Extraordinary times call for extraordinary measures. Quantitative Easing as an unconventional monetary policy response has worked according to any yardstick.

Unemployment had gradually and consistently dipped lower and inflation has not skyrocketed. Bernanke has done his bit. Now Janet Yellen, who assumes office tomorrow, has to slowly withdraw the liquidity injected in to the markets during the Bernanke era as the economy heals.

The markets can handle rising US real interest rates provided they rise in a gradual manner. A 1994 scenario wherein the US bond market witnessed a crash due to rapidly rising interest rates must be avoided.

Yellen’s dovish stance has market participants mildly bullish at the moment with the US stock market gradually inching higher to record highs. All Yellen has to do to cement Bernanke’s legacy as a successful Fed chairman is not to pull the plug on QE taper too much, too fast.