Brad DeLong asks Ben Bernanke a question in WSJ:
D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.
Free Exchange at The Economist:
I can’t imagine getting a more direct answer from the chairman than that. Mr Bernanke does not want to risk a de-anchoring of inflation expectations. He is willing to accept 10% or greater unemployment and the resulting economic and political fall-out in order to avoid that risk.
Personally, I think that Mr Bernanke owes us all a better explanation of why he has opted to place so much more emphasis on the price stability aspect of his mission than the full employment aspect. And, there should be a policy debate on this question, the resolution of which should inform the choice to reappoint (or not) Mr Bernanke.
But that’s clearly not going to happen. It’s unfortunate. But it is what it is. Best to focus on the next question—how to minimise the fall-out from five or more years of high unemployment.
Right now, real interest rates are too high, on a PPE basis (that’s Proof of Pudding is in the Eating): the economy is clearly operating far below capacity due to insufficient demand. The cost of that insufficient demand is enormous — not just in dollars of wasted output, but in severe social and psychological damage to the unemployed.
While real interest rates are too high, however, the short-term nominal rate is as low as it can go. So there are only two ways real rates can be reduced. Either the Fed has to buy long-term assets, driving down the wedge between short and long rates — the Gagnon proposal, which comes out of Ben Bernanke’s own work — or it needs to raise expected inflation. Or it could and probably should do both.
But it is, in fact, doing neither. Why? Because of fear that the Fed would lose credibility as a staunch inflation-fighter.
Future economic historians will, I believe, see this as fundamentally absurd — as absurd as the inflation fears that paralyzed the Bank of England in the early 1930s even as the world went into a deflationary spiral. Yes, there may someday be a 1970s-type episode in which the Fed needs to fight inflation, not encourage it — but it’s a long way off. Furthermore, why on earth would we imagine that the Bernanke Fed, by showing itself willing to inflict gratuitous pain in 2010, would make it easier for whoever is running the Fed in, say, 2020 to control inflation then, let alone that the tradeoff of real pain now versus hypothetical pain much later, if it even exists, is worth making?
Anyway, as far as I can see nobody is even trying to assess these alleged tradeoffs seriously. Instead, the notion of an unchanging inflation target — not to be revised even in the face of the worst slump since the Depression — has acquired a sort of mystical force; it has become identified with the notion of Civilization, in much the way that a previous generation assigned mystic significance to the gold standard.
Ben Bernanke, we’re told, is a great admirer of Liaquat Ahamed’s Lords of Finance; so am I. All the more irony, then, that Ben has, without realizing it, turned into Montagu Norman.
Many bloggers are commenting on Bernanke’s response to Brad DeLong’s question about whether the Fed should target three percent price inflation to stimulate aggregate demand and lower unemployment. I’ll offer two points:
1. We no longer have an independent central bank in this country, at least not for the time being. There is no particular reason to think current monetary policy is Bernanke’s personal decision, most of all because he is up for reappointment. He may well know better and arguably his remarks signal as such.
2. I still favor a two percent target (three would be fine too) for the rate of price inflation today. But it matters when we implement such a policy. The longer we wait, the more we miss out on its potential benefits. For instance it’s easier for AD-robust market conditions to signal to employers not to lay off workers than it is for market conditions to signal that workers should be rehired. The longer we wait, the more the inflation (and its expectation) loses its potency.
Furthermore nominal wages adjust sooner or later, even if the downward ride is a bumpy one with some negative cumulative spirals along the way. I don’t personally think we are close to the point where three percent is a bad target but that’s a guesstimate rather than based on hard science about the state of the labor market this spring. In any case three percent will become a bad idea at some point and we need to start asking ourselves when, no matter how good an idea it was a year ago.
I found this answer infuriating because he danced around all the important issues. He talked like we were back in the 1970s, when the biggest challenge was getting a lower level of actual and expected inflation. Bernanke doesn’t seem to realize that inflation targeting is not a one way street, it doesn’t mean always targeting inflation at current rates or lower. If you are serious about inflation targeting and have a symmetrical response function, then by necessity there will be times when you wish inflation to be a bit higher. And if this is not such a time, a year when we have experienced the first deflation since 1955, then will there ever be a time when the Fed tries to boost inflation expectations? If not now, when?
Now, I find monetary policy pretty confusing, which is to say that I find incompatible arguments persuasive. So I’m more or less agnostic about the policy the Fed ought to be pursuing. However, that the Fed ought to aim at something like a 3% inflation target is one of the arguments I find fairly persuasive. And Bernanke finds it fairly persuasive, too–at least “in theory.” So what’s wrong with the theory?!
I guess we could call it the “Pringles Problem”: Once you pop, you can’t stop! Bernanke seems to think that if the Fed tries to increase long-term inflation expectations once, a fair portion of the public will suspect that the Fed won’t be able stop, will act on the expectation of runaway inflation, and everything will go to shit. Or something like that. Or, in Bernanke’s words, “such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.”
OK. But I believe that the Fed can eat just one. Bernanke believes the Fed can eat just one. (NB: The “Pringles Problem” is extensionally equivalent to the “Lay’s Problem.”) But some significant part of the “the public” does not. How exactly does one measure the public’s position on the Pringles/Lay’s Problem? How exactly does one assess the public’s “confidence” in the Fed’s willingness to resist upwards shifts in inflation, such that one could assess the risk that a one-time bump in the inflation target will dangerously undermine this confidence? Is there survey evidence about this? Anything? If the Fed can’t credibly signal a commitment to a theoretically sound monetary policy, why not? Is it that Ron Paul will start doing handsprings and all the hucksters hawking gold on Glenn Beck will go bananas if the Fed even flinches? (Wouldn’t it be interesting if goldbug catastrophism helps prevent the very inflationary eschaton it banks upon?) Or what?
Anyway, my educated hunch is that there is no sound technocratic science here, just the educated hunches of cautious technocrats. May Bernanke’s gut be true.
My hunch is that the right quote to grasp for is R. G. Hawtrey’s, on those who in 1930-1933 were worried about excessive inflation. He said they were:
crying “Fire! Fire!” in Noah’s Flood.
OK. It’s 10% unemployment in America, not 23%. And the world’s second industrial power’s president is not about to appoint Adolf Hitler as Reichskanzler. So take a deep breath. Calm down…
Less vividly, you’ve no doubt heard a lot of talk about the importance of central bank independence. Ben Bernanke talks about the importance of central bank independence. Barack Obama and Larry Summers and Tim Geithner seem to believe in central bank independence so strongly that they won’t comment on this whole issue. Economists overwhelmingly believe in central bank independence. So do elite journalists. And the whole reason for central bank independence is supposed to be to provide a credible solution to this Pringle problem. Bernanke has a lot of power and a lot of independence and now is the time to put them to use.
Around The Sphere 