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Tuesday, October 25, 2005

Will the Bernanke Fed Retain Its Inflation Fighting Credentials?

I have heard and read worries that the Fed under Ben Bernanke will not be as committed to fighting inflation as the Fed under Greenspan, a worry I do not share. These quotes from a speech Bernanke gave in 2003 while he was a Fed governor called "A Perspective on Inflation Targeting" give information about Bernanke's views on how committed the Fed should be to fighting inflation (the whole speech is worth reading if you want to learn more about inflation targeting, and it gives links to related remarks by Bernanke and others on this topic). He uses the oil price shocks of the 1970s as an example and says that the inflation problems of that time were primarily the result of poor monetary policy not high oil prices, a statement of interest given the recent increase in energy prices:

However, a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly under control.

Although constrained discretion acknowledges the crucial role that monetary policy plays in stabilizing the real economy, this policy framework does place heavy weight on the proposition that maintenance of low and stable inflation is a key element--perhaps I should say the key element--of successful monetary policy.

I gave the Great Inflation of the 1970s in the United States as an example of what can happen when inflation expectations are not well anchored. ... Even today conventional wisdom ascribes this unexpected outcome to the oil price shocks of the 1970s. Though increases in oil prices were certainly adverse factors, poor monetary policies in the second half of the 1960s and in the 1970s both facilitated the rise in oil prices themselves and substantially exacerbated their effects on the economy. Monetary policy contributed to the oil price increases in the first place by creating an inflationary environment in which excess nominal demand existed for a wide range of goods and services. ... Without these general inflationary pressures, it is unlikely that the oil producers would have been able to make the large increases in oil prices "stick" for any length of time.

...The upshot is that the deep 1973-75 recession was caused only in part by increases in oil prices per se. An equally important source of the recession was several years of overexpansionary monetary policy that squandered the Fed's credibility regarding inflation, with the ultimate result that the economic impact of the oil producers' actions was significantly larger than it had to be. Instability in both prices and the real economy continued for the rest of the decade, until the Fed under Chairman Paul Volcker re-established the Fed's credibility with the painful disinflationary episode of 1980-82. This latter episode and its enormous costs should also be chalked up to the failure to keep inflation and inflation expectations low and stable.

Of course, as has often been pointed out, actions speak louder than words; and declarations by the central bank will have modest and diminishing value if they are not clear, coherent, and--most important--credible, in the sense of being consistently backed up by action...

And here are his misconceptions about inflation targeting from the same speech (the Bernanke and Mishkin 1997 paper he mentions is here):

Misconception #1: Inflation targeting involves mechanical, rule-like policymaking. As Rick Mishkin and I emphasized in ...Bernanke and Mishkin, 1997..., inflation targeting is a policy framework, not a rule. ... Inflation targeting provides one particular coherent framework for thinking about monetary policy choices which, importantly, lets the public in on the conversation. ... monetary policy under inflation targeting requires as much insight and judgment as under any policy framework; indeed, inflation targeting can be particularly demanding in that it requires policymakers to give careful, fact-based, and analytical explanations of their actions to the public.

Misconception #2: Inflation targeting focuses exclusively on control of inflation and ignores output and employment objectives. Several authors have made the distinction between ... "strict" inflation targeting, in which the only objective of the central bank is price stability, and "flexible" inflation targeting, which allows attention to output and employment as well. ... For quite a few years now, however, strict inflation targeting has been without significant practical relevance. In particular, I am not aware of any real-world central bank (the language of its mandate notwithstanding) that does not treat the stabilization of employment and output as an important policy objective. To use the wonderful phrase coined by Mervyn King, the Governor-designate of the inflation-targeting Bank of England, there are no "inflation nutters" heading major central banks. Moreover, virtually all (I am tempted to say "all") recent research on inflation targeting takes for granted that stabilization of output and employment is an important policy objective of the central bank...

A second, more serious, issue is the relative weight, or ranking, of inflation and ... the output gap... among the central bank's objectives. ... As an extensive academic literature shows, ... the general approach of inflation targeting is fully consistent with any set of relative social weights on inflation and unemployment; the approach can be applied equally well by "inflation hawks," "growth hawks," and anyone in between. What I find particularly appealing..., which is the heart of the inflation-targeting approach, is the possibility of using it to get better results in terms of both inflation and employment. Personally, ... I would not be interested in the inflation-targeting approach if I didn't think it was the best available technology for achieving both sets of policy objectives.

Misconception #3: Inflation targeting is inconsistent with the central bank's obligation to maintain financial stability. ...The most important single reason for the founding of the Federal Reserve was the desire of the Congress to increase the stability of American financial markets, and the Fed continues to regard ensuring financial stability as a critical responsibility... I have always taken it to be a bedrock principle that when the stability or very functioning of financial markets is threatened, ... the Federal Reserve would take a leadership role in protecting the integrity of the system...

And this may be of interest:

Given the Fed's strong performance in recent years, would there be any gains in moving further down the road toward inflation targeting? ... I believe that U.S. monetary policy would be better in the long run if the Fed chose to make its policy framework somewhat more explicit. ... To move substantially further in the direction of inflation targeting, ... the Fed would have to take two principal steps: first, to quantify (numerically, and in terms of a specific price index) what the Federal Open Market Committee means by "price stability", and second, to publish regular medium-term projections or forecasts of the economic outlook...

    Posted by on Tuesday, October 25, 2005 at 12:06 AM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (4)


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