THE STASH NOVEMBER 23, 2009
The Fed's dual mandate is to aim for full employment and price stability, but since Paul Volcker's day, it's safe to say the central bank has been more concerned with the latter than the former. But with unemployment at 10%, the Fed's popularity is suffering badly, and there's a real risk that the institution could become (more) politicized -- something that makes academics around the country shudder with fear.
According to The Economist's anonymous blogger, the Fed could actually help itself if it eased up on the hawkishness and allowed -- or was seen to allow -- some inflation:
There is simply no avoiding the conclusion that unemployment is a much, much bigger problem than inflation right now, and yet the Fed is unwilling to do anything more about unemployment, seemingly because it is concerned about inflation. What we want is some inflation! Rising prices would mean that the Fed is doing all it can do, counter-cyclically speaking.
An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation.
Awkward phrases like "was seen to allow" and "expected inflation" get thrown around here because of the much-derided but extremely useful theory of rational expectations. As it relates to monetary policy, rational expectations tells us that one way the Fed can make it feel like interest rates are below zero -- as many economists believe they should be -- is if it persuaded everyone that inflation was inevitable. Paul Krugman first made this idea famous writing about Japan in 1998:
If this stylized analysis bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate...might alleviate the problem; so might deficit-financed government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy - that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!
But how would the Fed actually do this? Krugman's answer back then was to introduce an explicit inflation target, an idea which he doesn't think would work in the current environment because the Fed doesn't have the stomach for it.
Ben Bernanke, for his part, has been a big proponent of inflation targeting. Here's what was on his mind back in 2003:
I believe [inflation targeting] would help to reduce the reliance of the Fed on complex and easily misinterpreted qualitative language in its communications with the public.
So targeting is something that academic theory says would help the economy out of its dire straits and also improve the functioning of monetary policy. Why hasn't Bernanke signed up yet?
I'm not sure, but here's one potential answer. At this year's Jackson Hole gathering, UC Santa Cruz's Carl Walsh presented a paper in which he investigates the idea of introducing a target (a price-level target in his case, which is conceptually similar) during a period of zero interest rates. His conclusion:
adopting [price-level targeting] in a crisis seems inadvisable. The benefits of [price-level targeting] rely heavily on its credibility, and the experience with [such targeting] suggests that credibility takes time [to] gain.
In other words, given how long it's typically taken for markets to warm up to inflation targets (which are used by many central banks around the world), it's a little too late for the Fed to introduce a price target once it's already in a period of great uncertainty.
But better late than never, right?