Thursday, December 17, 2009

Bernanke Should Go!.

Brad Delong asked why Bernanke hasn't adopted a 3% inflation target. He responded:

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.

I could understand Bernanke arguing that three percent inflation would be a bad thing. I would agree.

I could understand him arguing that higher inflation would not result in higher expenditure. Or that higher expenditure would not result in higher output or employment.

What I cannot accept is the notion that a commitment to price level stability is important because it "enhances the effectiveness of monetary policy," and his worry that targeting a three percent inflation rate would "undermine the effectiveness of monetary policy going forward."

For more than twenty years, making vague statements about high employment and price stability, while making monthly adjustments in short term interest rates with the apparent goal of having the CPI rise at a 2 percent rate from where ever it happens to be, appeared consistent with better macroeconomic performance than in the past. Unfortunately, this approach was not robust in the face of financial problems for a handful of large Wall Street investment banks.

Bernanke is just too focused on putting humpty dumpty back together. All during the crisis last fall, the focus was on jump starting securitization markets. Now, Bernanke appears willing to accept low production and high unemployment for years, because otherwise, they won't be able to return to their traditional approach to monetary policy. And then there is this fantasy that they are going to get the regulations right this time so that there won't be the sorts of financial disruptions that made their traditional approach to policy ineffective!

A new approach is needed. Rather than a vague statement about price stability and an actual policy of two percent CPI inflation from a drifting base, a clear commitment to a slow, steady growth path for nominal expenditure is needed. With a three percent growth path for nominal expenditure, high inflation, much less accelerating inflation, is impossible. Inflation expectations would be anchored without keeping the Fed from reversing catastrophic decreases in nominal expenditure.


  1. "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."

    It sounds to me as if he is arguing that a 3% target undermine the fed's political power because people fear inflation, which would then prevent it from executing monetary policy.

  2. Think about this...

    It is just 3% inflation. That is just one percentage point higher than the 2% we have been aiming at for years now... Oh.. you didn't know? The "price stability" we promise is really 2% inflation? The inflation we actually have is not just an uncontrollable fluke but our intentional policy? And what is our reasoning? We need it so that our interest rate targeting regime can work in the context of deflationary mistakes?

    Can't let the average American in on that tidbit of information. Keep it all vague.

  3. If Bernanke went, who would replace him? Maybe we should be willing to embrace the devil we know.

  4. Yah, Bill, thats basically what I was thinking, more or less.

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