"Bernanke's Bold Prose"

Mohammed El-Arian says Ben Bernanke can talk all he wants, but the credibility of his message about inflation depends upon the actions of fiscal authorities and is thus largely out of his hands:

Mohamed El-Erian on Bernanke’s bold prose, FT Alphaville: From Pimco’s chief executive…

While it may not rank quite as high as his appearance on the US news show ‘60 Minutes’ a few months ago, Chairman Bernanke’s Op Ed in today’s Wall Street Journal is nevertheless notable and important. It represents a bold attempt by the Federal Reserve to reach out broadly and pre-empt mounting concerns about the challenges facing monetary policy.

Bernanke’s bottom line is clear:  “Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so.”   ... Bernanke is signaling that the Fed is aware of the need to re-assure markets of its ability to strike that delicate balance between deflationary and inflationary concerns. ...

While ... this is important, it does not constitute major news as such.  Indeed, Bernanke has today confirmed a view that has increasingly prevailed in financial markets:  there will be no early hike in interest rates; and when the time comes to tighten monetary policy, the sequence will involve dealing first with the excess reserves. Yet this is not sufficient to ensure that the US is indeed able to balance well deflationary and inflationary risks.

To move from a necessary condition to one that is both necessary and sufficient, one must also consider what, increasingly, is the large elephant in the room when it comes to policies — namely, the design and conduct of fiscal policy.  This is an area where challenging short and longer-term imperatives need to be reconciled over time, and at several level of local, state and national governments. ...

After being heavily involved in stabilizing a highly disrupted economy, the Fed is transitioning from the driver seat to the passenger seat.

By virtue of its greater flexibility and responsiveness, the Fed ended up assuming the main role in responding to the crisis, with fiscal and other agencies (including the FDIC) playing important support roles. It is now the turn of the fiscal agencies to assume the main role, with the Fed and others playing the support roles.

Bottom line:  we have now entered the phase where fiscal policy is the more important determinant of the ability of the US to balance the risks of deflation and those of inflation. And, here, the jury is still out.

If we fail to make the changes in health care reform that are needed to bring the long-term budget into better balance, there will come a time when the Fed faces a choice about whether to monetize the debt and create inflation, or to refuse to monetize the debt potentially send interest rates very high causing the economy to stall. So it's not completely out of their hands. The Fed has faced this choice before, and its independence allowed it to send a message to fiscal authorities that it was willing to take whatever steps are necessary, including causing a recession, to prevent monetizing the debt and creating an inflationary environment. As Thomas Sargent notes in his book "Dynamic Macroeconomic Theory":

A game of chicken seemed to be occurring in the United States from 1981 to 1985 because the Fed announced a policy that is feasible only if the budget swings toward balance in a present value sense, whereas Congress and the President set in place plans for government expenditures and taxes that imply prospective net-of-interest deficits so large that they are feasible only if the Fed eventually creates more inflation. In such a situation, something has to give.

And, due to the degree of independence that it had, it wasn't the Fed that eventually gave in. With a less independent Fed, I'm not sure we get that outcome. (I should note that people such as Jamie Galbraith argue that fighting inflation during this time period was the wrong policy to pursue - one part of the the argument is that it suppressed wages and made workers worse off - but this is a point on which we disagree, and the general view within the profession is that the Volcker Fed acted wisely.)