Fed: “limited and tentative”

{Still waiting for SOTU! This note is from exactly 11 years ago. We still don´t know where the Fed is headed!]

Robert Samuelson writes “Where is the Federal Reserve headed?”:

Yellen recognizes the dismal choices and strives to cultivate confidence as a way of blunting the conflicts. At her recent news conference, she emphasized that the Fed, though it wants the freedom to tighten policy, will not be hurried into premature or sharp rate increases. Even after the initial change, she said, “our policy is likely to remain highly accommodative.” Money will continue to be cheap. Investors need not make market-disruptive changes in their portfolios.

So far, this soothing strategy has succeeded. Whatever happens, there remains a larger historic question: How did an agency that seemed so powerful and commanding in one era become so limited and tentative in the next?

I not only liked but also loved the “limited and tentative” description.

I believe Samuelson´s question has a simple and straightforward answer. It happened when the Fed, after the change of guard from Greenspan to Bernanke, forsook nominal stability to pray at the altar of inflation targeting.

That this would happen if Bernanke got the job was inevitable. In January 2000, long before even becoming a Fed Governor, let alone its Chairman, Bernanke wrote (with Mishkin and Posen) an op-ed in the WSJ titled “What happens when Greenspan is gone?”:

U .S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue; even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.

We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation; the source of the Fed’s current great performance; but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.

On the last sentence on “transparency and accountability”, one would think exactly the opposite happened from reading this op-ed at the WSJ today:

The calls in Washington to “audit” the Federal Reserve are not for a narrow, bean-counting review of the institution’s financial statements. The audit’s goal is more fundamental: to assure that the checks and balances in a democratic government also apply to central bankers. It means figuring out how our elected representatives can effectively oversee unelected monetary “experts.”

If Bernanke had only understood that Greenspan in practice had been (more or less) committed to nominal stability, understanding that real, or supply, shocks should be treated carefully, he wouldn´t have let nominal spending tank in 2008.

However, Bernanke should have understood because in a 1997 paper with Mark Gertler and Mark Watson, they concluded:

Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.

Bernanke mentions Japan as an exception to the success of inflation targeting. He missed an important lesson there because Japan was, in fact, the first victim of an “no holds barred” IT regime. To make a long story short, after the inflation explosion in Japan in the mid-1970s (when inflation reached 25%), inflation became Japan´s public enemy #1. An inflation target was never made explicit but every housewife in the land new that the BoJ pursued “price stability”.

With that background, in 1989, when the Ministry of Finance introduced the first installment of the consumption tax, prices jumped. Immediately the BoJ clamped nominal spending. This was repeated after the second installment in 1997, with even more dire consequences!

In short, Bernanke´s “best bet” was the wrong bet. Instead of “powerful and commanding” the Fed became “limited and tentative”. But the solution presents itself clearly. Have the Fed pursue an explicit NGDP Level Target. Very quickly it will once again become “powerful and commanding” and the “instrument rules” advocates like John Taylor will have to change their tune! More significantly still, Krugman´s “liquidity trap” meme will fade!