Ben Bernanke: We Cannot Practice Safe Popping

Brad Delong is battling the false perception that Ben Bernanke is soft on inflation, a point made here as well, and Brad is right. If analysts continue to spread this myth about Bernanke gleaned from a misreading of a statement about how to prevent costly disinflation, the Fed will be forced to demonstrate its commitment to price stability, and forcing the Fed to increase interest rates to establish the appropriate credentials is not desirable.

What about another concern regarding monetary policy recently, asset bubbles? Will Bernanke change the Fed's current view that managing asset prices is outside of its purview? This statement from an American Economics Review Papers and Proceedings volume from 2001 should help to clarify Bernanke's position:

Should Central Banks Respond to Movements in Asset Prices?, by Ben S. Bernanke and Mark Gertler: ...The inflation-targeting approach gives a specific answer to the question of how central bankers should respond to asset prices: Changes in asset prices should affect monetary policy only to the extent that they affect the central bank’s forecast of inflation. ... In use now for about a decade, inflation targeting has generally performed well in practice. However, so far this approach has not often been stress-tested by large swings in asset prices. [Author web page versions here and here.]

The stress testing he mentions, an indication his view on is not yet etched in stone, is now being performed and his hand will soon be on a key lever in the process, interest rates. But this doesn't explain why the Fed shouldn't respond. For more on that, here's a 2002 Fed speech from Bernanke. Once again, we see that his mind is not entirely made up on this issue, but he is persuaded by arguments that bubbles cannot be reliably identified in time to prevent them, and even if they could, monetary policy is too blunt an instrument to use if the intent is to prick individual bubbles:

Asset-Price "Bubbles" and Monetary Policy, by Ben Bernanke: ... My talk today will address a contentious issue, summarized by the following pair of questions: Can the Federal Reserve ... reliably identify "bubbles" in the prices of some classes of assets, such as equities and real estate? And, if it can, what if anything should it do about them?  ... My suggested framework for Fed policy regarding asset-market instability can be summarized by the adage, Use the right tool for the job. ... The Fed ... has two broad sets of policy tools: It makes monetary policy, which today we think of primarily in terms of ... setting ... the federal funds rate. And, second, the Fed has a range of powers with respect to financial institutions, including rule-making powers, supervisory oversight, and a lender-of-last resort function ... The first part of the prescription implies that the Fed should use monetary policy to target the economy, not ... asset markets. ... [F]or the Fed to be an "arbiter of security speculation or values" is neither desirable nor feasible. ... The second part of my prescription is for the Fed to use its regulatory, supervisory, and lender-of-last-resort powers to protect and defend the financial system.

...[T]he framework just articulated is not universally accepted  ... And, in my opinion, the theoretical arguments that have been made for the lean-against-the-bubble strategy are not entirely without merit. ... If we could accurately and painlessly rid asset markets of bubbles, of course we would want to do so. But ... the Fed cannot reliably identify bubbles in asset prices. ... [and] even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them. ... As a matter of logic, the fact that bubbles are difficult to identify with precision does not necessarily justify ignoring potential ones ..: Even if we can measure bubbles only imprecisely, is the optimal response of monetary policy to a perceived bubble literally zero? Shouldn't there be at least a bit of response, for "insurance" purposes? ... [But] Is it plausible that an increase of ½ percentage point in short-term interest rates, unaccompanied by any significant slowdown in the broader economy, will induce speculators to think twice about their equity investments? ... Although neither I nor anyone else knows for sure, my suspicion is that bubbles can normally be arrested only by an increase in interest rates sharp enough to materially slow the whole economy. In short, we cannot practice "safe popping," at least not with the blunt tool of monetary policy. ... One might as well try to perform brain surgery with a sledgehammer. ...

A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed...

Things could change in the future under Bernanke as new ideas and new research on the Fed's role in managing asset price bubbles comes to light, but I don’t expect much, if any change in the Fed's hands-off policy regarding asset price management, and if there is change, it won't be immediate. One final note. I was struck in reading this speech how similar it is to very recent discussions emanating from FedSpeak on this issue, an indication of the influence Bernanke has within the Federal Reserve.

[Update: The Washington Post discusses this here.]

Comments

[William Polley]

Very true. I almost quoted that paper in my blog post today, but chose the agency cost papers instead.

Minor point: I'm not sure that the similarity of Bernanke's words in the speech that you cite and the recent Fedspeak is a sign of Bernanke's influence per se. William Poole (St. Louis) gave a speech about a year earlier that said something similar. I think it's got a pretty long intellectual tradition at the Fed. Bernanke is totally in sync with it, of course. That much is true.

[anne]

http://www.nytimes.com/2005/10/26/opinion/26grant.html?ex=1287979200&en=1f4592430c5ee44b&ei=5090&partner=rssuserland&emc=rss

October 26, 2005

Future Shock at the Fed
By JAMES GRANT

PRESIDENT BUSH's choice to succeed Alan Greenspan as chairman of the Federal Reserve Board has raised a roar of approval. Economist, scholar, presidential counselor and former Fed governor, Ben S. Bernanke is a nominee from central casting.

But there is one rub. The man with the gray beard and the perfect résumé - winner of the South Carolina state spelling bee, Ph.D. from the Massachusetts Institute of Technology, former chairman of the Princeton economics department - professes to believe the impossible. He insists that the Fed can keep the economy chugging and prices stable just by pushing a single interest rate (the so-called federal funds rate) up and down.

Alan Greenspan, of course, has long espoused the same impossibility, as have other Federal Reserve officials and many private economists. A little thought experiment will reveal their error.

Let us say that Mr. Bernanke's field of expertise was energy prices rather than interest rates, and that the president named him to the Department of Energy rather than the Federal Reserve. If Mr. Bernanke then ventured a long-term oil-price forecast, would anyone even bother to write it down? Would anyone expect him, once confirmed, to actually fix the price?

Those who did would have to call the idea by its discredited name - price controls - and would have to explain why the secretary-designate knew better than the market at which price the supply of oil would meet the demand for oil. They would also have to explain why this episode in price controls would turn out better than the long series of flops that preceded it. The world would laugh.

Yet we seem to accept, and even desire, exactly such ludicrous claims of foresight from a Fed chairman. It follows that anyone who is willing to take the job as Fed chief is, by that reason, unqualified to hold it.

Wall Street, of course, has other ideas....

[anne]

James Grant has been bearish for 25 years, as far as I understand, but he writes well and represents a host of perpetual bears.

[realist]

greenspan is soft on inflation, and bernanke will be soft on inflation. aside from things made in china,prices for buying a house, heating a house, filling up a car, paying for your kid's college, all types of insurance, ect are up dramatically. the cpi is bullcrap. it's skewed to keep cola's down.

the mystery of long term bonds with low interest rates in the face of fed funds rates rising, is no mystery. if greenspan didn't keep raising short term rates, the dollar would tank. if the dollar dropped, foreign investors would be reluctant to buy treasuries and gse's unless rates went up to cover the dollar weakness. consequently, greenspan has actually been keeping a lid on long term rates by raising short term rates.

i'm sure dr. bernanke figured out what happened to paul o'neill and larry lindsey, when they called debya on his vodoo economics. bernanke, right after katrina, said that making the bushco tax cuts permanant was a priority. he is bought and paid for.

[realist]

greenspan is soft on inflation, and bernanke will be soft on inflation. aside from things made in china,prices for buying a house, heating a house, filling up a car, paying for your kid's college, all types of insurance, ect are up dramatically. the cpi is bullcrap. it's skewed to keep cola's down.

the mystery of long term bonds with low interest rates in the face of fed funds rates rising, is no mystery. if greenspan didn't keep raising short term rates, the dollar would tank. if the dollar dropped, foreign investors would be reluctant to buy treasuries and gse's unless rates went up to cover the dollar,s weakness. consequently, greenspan has actually been keeping a lid on long term rates by raising short term rates.

i'm sure dr. bernanke figured out what happened to paul o'neill and larry lindsey, when they called debya on his vodoo economics. bernanke, right after katrina, said that making the bushco tax cuts permanant was a priority. he is bought and paid for.

[spencer]

If the relationship between fed funds and the stock market PE is about one to one -- a 100 basis point changes in rates causes roughly a 100 basis point change in the market PE --and that is what regression models imply the Fed can not dampen a stock market bubble without damaging the economy.

If the relationship is linear at a higher PE it takes even more of a change to hurt the market. If the PE is 10, a 100 point moves reduces it to 9 -- a 10% change.
But if the PE is 20 a 100 point move cuts the PE to 19, but this is only a 5% move, As the PE moves higher as it did in the 1990s it takes an even bigger increase in Fed Funds to hurt the stock market.

This implies that in the late 1990s for the fed to deflate the stock bubble would have required a tightening that would have sevely damaged the economy.

Interestingly, if you try to add a dummy variable for margin requirements to a good regression equation of the market PE it turns out to have an insignificant impact, and the coefficient has the wrong sign.

[save_the_rustbelt]

And what of the slack in the labor market?

If this is a recovery, what happens when the economy goes south?

Bush-o-nomics is not getting it down.

[Movie Guy]

rustbelt,

As you know, we're not going to have a real recovery or improvements in GDP growth at this stage of operating under economic hydrology theory.

It appears that there are few good tools left in their bag once the next recession gets underway. Which growth engines are left? I expect the current account deficit to take another hit while we promote the housing model once again. And outsourcing/offshoring continue to gain steam.

They really are in trouble.

[Jay]

Civil Rights Pioneer Rosa Parks, 92, Dies
By THE ASSOCIATED PRESS

http://www.nytimes.com/aponline/national/AP-Obit-Rosa-Parks.html

DETROIT (AP) -- Nearly 50 years ago, Rosa Parks made a simple decision that sparked a revolution. When a white man demanded she give up her seat on a Montgomery, Ala., bus, the then 42-year-old seamstress said no.

At the time, she couldn't have known it would secure her a revered place in American history. But her one small act of defiance galvanized a generation of activists, including a young Rev. Martin Luther King Jr., and earned her the title ''mother of the civil rights movement.''

Mrs. Parks died Monday evening at her home of natural causes, with close friends by her side, said Gregory Reed, an attorney who represented her for the past 15 years. She was 92.

Monique Reynolds, 37, a native of Montgomery, Ala., called Mrs. Parks an inspiration who had lived to see the changes brought about by the civil rights movement.

''Martin Luther King never saw this, Malcolm X never saw this,'' said Reynolds, who now lives in Detroit. ''She was able to see this and enjoy it.''

In 1955, Jim Crow laws in place since the post-Civil War Reconstruction required separation of the races in buses, restaurants and public accommodations throughout the South, while legally sanctioned racial discrimination kept blacks out of many jobs and neighborhoods in the North.

Mrs. Parks, an active member of the local chapter of the National Association for the Advancement of Colored People, was riding on a city bus Dec. 1, 1955, when a white man demanded her seat.

She refused, despite rules requiring blacks to yield their seats to whites. Two black Montgomery women had been arrested earlier that year on the same charge, but Mrs. Parks was jailed. She also was fined $14.

U.S. Rep John Conyers, in whose office Mrs. Parks worked for more than 20 years, remembered the civil rights leader as someone whose impact on the world was immeasurable, but who never sought the limelight.

''Everybody wanted to explain Rosa Parks and wanted to teach Rosa Parks, but Rosa Parks wasn't very interested in that,'' he said. ''She wanted them to understand the government and to understand their rights and the Constitution that people are still trying to perfect today.''

...

[dave iverson]

Bernanke: "A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including ... and a willingness to play the role of lender of last resort when needed..."

I hope that Bernanke plays the game well. I hope too that he understands the limits of throwing money at problems. It may work for a while, but after a while all it does is engender ever bigger bubbles -- culminating now in what Stephen Roach calls "the Mother of all asset bubbles."

[anne]

Rosa Parks deserves to be much mentioned and remembered. There is always much need for such gently brave souls.

[dave iverson]

A couple of comments up I said, of Bernanke, "I hope too that he understands the limits of throwing money at problems." To be more precise, I hope that Bernanke understands the limits of throwing paper or promises at problems. It is bad enough to waste money by throwing it at problems if you are an individual or a business. It is worse to throw paper around if your are the central figure of the Fed, keeper of the world's reserve currency. For more, see James Grant's commentary titled "Future Shock at the Fed" in today's NY Times. http://www.nytimes.com/2005/10/26/opinion/26grant.html