The Fed Argues with Itself
How Ben Bernanke walked away from flexibility from January to AprilLet me just say, first off, that I am terribly confused -- I think that is the word I want to use -- by Ben Bernanke's news conference yesterday following the FOMC meeting.
I understand that he doesn't have support on the Committee to move monetary policy more in the dovish direction, and doesn't want to send a false signal to markets. But I am confused because if you read Bernanke's quotes carefully, as you right well should, it is indisputably to the "right" of where he was a few months ago. Not ten years ago, with his Japan work, which I haven't looked at yet but am under the impression from Scott Sumner and Paul Krugman that it's remarkably contrary to what is going on today.
Here's the quote which most confused me:
The question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly faster reduction in the unemployment rate...The view of the committee is that that would be very reckless.Now, compare that to what the Committee said in its "statement of longer-run goals and policy strategy" in late January:
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.In my mind, these two statements are directly contradictory. In the first, Bernanke says that a policy which raised the inflation rate temporarily above trend to bring down unemployment faster would be "very reckless." In the second, Bernanke says that the Committee will raise the inflation rate temporarily above trend in order to bring the unemployment rate down faster.
OK, so it doesn't say that explicitly, rather in Fedspeak. But read the second quote again. The Fed "follows a balanced approach in promoting" price stability and full employment "taking into account the magnitude of the deviations and the potentially different time horizons." The most logical translation of that statement, to me, is that when one of the variables (inflation or unemployment) is really far off trend, and is likely to stay that way for a while unless we do something about it, we are willing to tolerate some small deviations in the other variable to bring the off-track one back on track. That could mean deviating from full employment if inflation were to rise to 10 percent; it also means, unmistakably I think, that the Fed "actively" intending to seek temporarily higher inflation to reduce unemployment.
Not to rub it in, but this is what I said would happen with the Fed's flexible inflation target:
I see two outstanding problems...First, since there is an explicit commitment only to an inflation target, such central banks tend to be insufficiently flexible in correcting deviations in real output. This is perhaps because any deviation in inflation jeopardizes the credibility of the target. Second, such central banks have not managed to make explicit how they will be flexible -- i.e. what deviation in inflation they are willing to tolerate in order to stabilize real output. This means that during recessions, a flexible inflation target often introduces considerable uncertainty in monetary policy at the worst possible moment.Also, I don't understand another thing. Bernanke says that the Fed's not willing to rise above its inflation target. But that's not what a target is. You're supposed to err evenly, on both sides, above and below, for a target. Is 2 percent annual change in PCE an inflation ceiling? That would be a small wording difference, but it would mean all the world. Greg Ip of The Economist says that's not true, but I simply don't see how that can be, given the data we have. Moreover, it's what the Committee is saying they want in their projections: PCE inflation below 2 percent know, but which approaches a limit of 2 percent from below.
A target where a central bank must risk its credibility to correct for cyclical deviations is not a target designed for a reality, a world where there are cyclical deviations. The ideal target is one where the bank's credibility is enhanced by countercyclical accommodation, or where the "default track" is countercyclical accommodation. This is not such a target, Bernanke seems to admit:
Central bankers appreciate that credibility helps stabilize inflation and makes the real sector more stable. The costs of getting it back when you lose it are enormous...[If the Fed can’t convince investors that it can contain inflation] we would in fact have less rather than more flexibility to use accommodative monetary policy to achieve our employment goals...We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four, five years. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.So credibility, in Bernanke's mind, is something that is spent when the Fed acts countercyclically. That is really, really bad news, because it is the signature of ill-designed monetary policy.