Deconstructing Bernanke’s Speech

Pretty disappointing, but with one silver lining.  We pretty much know where the ”Bernanke put” is, he drew a line at roughly 1% core inflation.  That means no more “depression economics.”  Let’s get costs down and we can get a faster economic recovery:

1. Payroll tax cuts (at the margin, employer only.)
2. Replace unemployment extended benefits with large lump sum payments to the unemployed.
3. Temporary (two year) minimum wage cuts to $6.50.

Of course this won’t happen, but it would promote faster growth if it did.  They are things Obama could try.  Now for the speech:

Maintaining price stability is also a central concern of policy. Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives.

Translation:  The Fed defines price stability as about 2% inflation, and it’s running around 1% (core inflation.)  Bernanke thinks that’s a bit lower than desirable.  But then there is also this:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability.

Aaaargh!!  So which is it?  Is inflation too low, or not?

I wish those prominent economists calling for 4% inflation had followed my advice.  Call for level targeting.  Draw a 2% trend line for core inflation from September 2008.  We are now 1.4% below that trend line.  Shoot for getting back to trend.  I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast NGDP growth to get 3.4% core inflation over 12 months.  Or 2.7% over 24 months.  You’ll never convince the Fed to change its inflation target to 4%, and there is no need to try.

But Bernanke definitely does understand the logic of the argument I have been making in recent posts:

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.  (italics added.)

Translation:  “Listen you inflation hawks, if things get even a tiny bit worse we will need more stimulus not just to boost growth, but to prevent further disinflation.”

I think we are already there, where more nominal growth is a win/win, and my hunch is that (to a lesser extent) Bernanke agrees.  After all, he basically said that in the first quotation I gave you, which I take to be his true feelings.  The hawks would never have said inflation is too low.  Bernanke is a patient man, but he is running out of patience.  Let’s hope the three new Board members push him hard this fall.

So if Bernanke wants to do more, why doesn’t he say so?  He explained why, if you read between the lines:

Central banks around the world have used a variety of methods to provide future guidance on rates. For example, in April 2009, the Bank of Canada committed to maintain a low policy rate until a specific time, namely, the end of the second quarter of 2010, conditional on the inflation outlook.4 Although this approach seemed to work well in Canada, committing to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves (as the Bank of Canada was careful to state). An alternative communication strategy is for the central bank to explicitly tie its future actions to specific developments in the economy. For example, in March 2001, the Bank of Japan committed to maintaining its policy rate at zero until Japanese consumer prices stabilized or exhibited a year-on-year increase. A potential drawback of using the FOMC’s post-meeting statement to influence market expectations is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality. The Committee will continue to actively review its communication strategy, with the goal of communicating its outlook and policy intentions as clearly as possible.

Translation:  We can’t communicate a clear objective because unlike in Canada and Japan, I can’t get those hawks to agree with my view of the appropriate “comprehensive framework.”  We will try to make our intentions as clear as possible, if we can ever agree on what they are.

What if more stimulus is needed, does the Fed have more ammo?

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

So Congress and the President are desperately looking for ways to boost demand, w/o ballooning the deficit.  The Fed has such tools, but sees no need to use them.  And what is the most likely tool?

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. (Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit.) To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. Indeed, by providing maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy stance–and thereby helping to anchor inflation expectations–the Committee increases its own flexibility to use securities purchases to provide additional accommodation, should conditions warrant.

Translation:  It worked last time (March 2009), there are a few minor problems, but we have addressed those problems.  He mentions other ideas like better communication and lower IOR, but you get the impression that he is much less enthusiastic about those ideas.  My guess is that he would only do a comprehensive stimulus with all three tools if things got really bad.  Actually things are really bad; I mean  if things got really, really bad.  If 3rd quarter NGDP growth comes in around 3% or lower, look for more QE in the fall (when the three new members are seated.)  BTW, I am less confident than Bernanke that QE worked last time.  But it is definitely better than nothing.

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