The Federal Reserve faces a tricky balancing act ahead: how to make sure an economic recovery gains needed momentum, while guarding against inflation or another bubble-induced crisis.
"Although we have avoided the worst, difficult challenges still lie ahead," Mr. Benanke said. "We must work together to build on the gains already made to secure a sustained economic recovery."
Economists generally agree that, for now, sustaining a recovery is Job 1 for policymakers. Fears of a continued collapse in consumer spending have receded. But consumers and banks are still in fragile shape.
Need for a careful 'exit' from massive monetary support
The Federal Reserve's recent policy statements imply that its short-term interest rate for banks will remain near zero percent, probably into next year. But as the global economy gains a firmer footing, the Fed could come under pressure to implement an "exit" from the massive monetary support it has provided during the financial crisis, forecasters say.
"The [central bank's] transition from ultra-expansionary policy to a neutral stance may be very tricky," economists at the investment firm Morgan Stanley write in a report for clients this week.
Without a successful exit strategy, a return of inflation worries might push up private-sector interest rates or weaken investor confidence in the US dollar. Another risk is that, beyond inflation in consumer prices, the prices of assets such as commodities, stocks, or real estate could start surging again thanks to the Fed's open-spigot monetary policies. Asset bubbles have played a central role in the past two US recessions, and the Fed is weighing carefully how to avoid a repeat of the boom-bust cycle.
The Morgan Stanley researchers say there's no guarantee that the Fed and other central banks globally will be able to find the right policy balance.
"Central banks may find themselves hiking [interest rates] into a weak recovery to quell asset prices," which could restrain much-needed growth in the economy, they say. Or, if central banks maintain loose policies on interest rates and credit, they might "allow asset prices to rise but risk inflating another bubble."
How the Fed might adjust policy
Withdrawing the above-normal stimulus of monetary policy will probably be a gradual process – and interest-rate hikes won't necessarily be the first step. The Fed could slow and then cease its purchases of mortgage debt securities, for example, effectively putting upward pressure on mortgage rates. The Fed can also raise its own short-term lending rate for banks, and it could start selling some of the assets it has purchased to help prop up credit markets in the past year.
The Fed's mandate from Congress is to seek both price stability and full employment for the economy, but price stability is widely seen as the goal the Fed must emphasize when push comes to shove.
If inflation does perk up, Bernanke has told lawmakers recently that the Fed will have the courage to hold inflation in check, even if unemployment remains high.
Quest for 'a new financial regulatory framework'
The bankers' summit at Jackson Hole, Wyo., is an annual event, and this year it comes as Bernanke's own job is up for review. President Obama could reappoint him or name someone else to replace him in 2010.
Most of Bernanke's speech, titled "Reflections on a Year of Crisis," was backward-looking. He recounted the storms encountered and the Fed's response. He said he expects that by next year's meeting in the Tetons, the Fed will have made substantial new progress on both economic growth and in building "a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years."
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