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Tuesday, November 22, 2005

Should Bernanke Focus on Asset Price Bubbles Instead of Explicit Inflation Targets?

I think this commentary misses something. The theme is that Bernanke's use of his initial honeymoon period to push inflation targeting will cause a loss of focus on more important issues such as whether Fed creates, through accommodative policy, asset price bubbles and if it does the extent to which policy ought to be directed at them:

Bernanke should rethink his monetary ‘Maginot Line’, by Peter Hartcher, Financial Times: Ben Bernanke... earnestly pledged to continue the policies of Alan Greenspan... But ... [i]n his Senate confirmation hearing ..., Mr Bernanke began a campaign to give the Fed an explicit, public target for its inflation rate... He appeared to be committing his honeymoon period, and all the goodwill and latitude that come with it, to imposing this one reform. Is this a good idea? ... For the US to introduce one today ... would be like creating a monetary Maginot Line. An inflation target for the US, like the famous line of French defences in the second world war, would do no real harm. But, like the fixed defensive artillery that was supposed to keep the Germans out of France, it would not be very useful either. ... At first glance, it is hard to see why the incoming Fed governor feels the need to install an inflation-targeting regime. The Fed already has one, although it is undeclared, or “covert”. ... Now Mr Bernanke has arrived proposing the Fed publicly disclose its inflation target and ... “From his earlier speeches he wants an inflation target of 1 to 2 per cent,” said Bill Dudley, chief US economist for Goldman Sachs. ...

It is hard to see why Mr Bernanke is devoting all his initial political capital to this issue. Perhaps, like the Maginot Line, it is all about the last war. ... The clue to what is driving Mr Bernanke may be found in a speech he gave in March 2003: “Credibility is not a permanent characteristic of a central bank; it must be continuously earned.” In effect, an untested Fed chairman is seeking to establish through a formal arrangement the credibility that his two towering predecessors won through action. But in the meantime, ... there are other defensive works left undone. The experience of Japan in the 1980s, and the US in the 1990s until today, is that easy money no longer flows into traditional inflation, but into asset price inflation. ... [O]ther central banks around the world – including those of Britain, Australia, Canada, New Zealand and Norway – started publicly addressing the question of how to deal appropriately with bubbles. The US central bank, under Mr Greenspan and, shortly, Mr Bernanke, avoids focusing on it. ... What will happen when, as there inevitably will be, there is another bubble in asset prices but no clear threat of inflation? Under current Fed doctrine, the Fed would do what it did during dotcom mania – wait for the burst and the recession that follows. Is there a better way? This is the big new agenda item for central banks, but Mr Bernanke is preoccupied with the old agenda. An inflation target does not hold any answer. ...

The choice to move to explicit inflation targets depends, of course, on the costs and benefits of doing so. Rather than debate the benefits of explicit targets, I want to focus on the cost. In this commentary, the main criticism of Bernanke pushing explicit inflation targets is that the opportunity cost, a potential loss of focus on asset bubbles, is large. First, plenty of academic research is underway on the question of how best to respond to asset price bubbles, research Bernanke knows well, and this large body of research is relatively unaffected by what Bernanke does or does not push within the narrow confines of the Board of Governors and the FOMC. But in addition, there is no necessary inconsistency between an explicit inflation target and combating asset price bubbles. The commentary talks about an explicit consumer price index target, but there are many potential price indexes to use as a target and this too is an active area of research. If you do use an explicit target, what index should be used? Core inflation? In measuring core inflation, what prices are thrown out? Where is the line between including and excluding a price? Should the index include (or be limited to) wage inflation? Should asset prices be included in the index? If asset prices are included, then bubbles are addressed within the explicit target and the concerns in the commentary are alleviated.

There are lots of misperceptions about why the Fed focuses on core inflation and what core inflation represents. Here's one line of thinking in this area. When there are wage and price rigidities, inflation distorts relative prices. This causes both resource losses and resource misallocations both of which lower welfare. The goal of policy is to remove these welfare reducing distortions and one way to do that is to stabilize prices. What this means is that the prices to focus on in stabilization policy are the prices that are the most sluggish because these are the prices most likely to be distorted by inflation. In general these are not oil prices, stock prices, housing prices, food prices, and so on, all of which are very flexible. This explains why a policy maker may want to focus on core inflation rather than total inflation (and also suggests how core inflation might be defined), and why asset and other flexible prices may not be included in the core measure. But there are other points of view and, as I noted, this is an active research area, one I have no doubt whatsoever Bernanke will keep up with.

    Posted by on Tuesday, November 22, 2005 at 12:43 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (7)


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