Fed Governor Ben Bernanke, a Princeton University economist, champion of inflation targeting, and defender of the central bank’s recent war to fight an alleged deflation, has been nominated by President Bush to chair the Council of Economic Advisers. In light of the news, does Bernanke now jump onto the fast track for succeeding Fed Chairman Alan Greenspan, who by law must step down from that role on January 31, 2006.
“If he goes there and proves to be effective in the political arena, I think it could enhance his prospects for succeeding Greenspan,” said John Shoven, director of the Stanford Institute for Economic Policy Research, tells Reuters.
Political experience is not to be dismissed when it comes to building a resume that aids in the race to receive a nod from the President to succeed Greenspan. On that score, Bernanke’s odds for becoming the new maestro of monetary policy have moved up a notch. Whether that ultimately gives him a leg up on the competition is an open question, of course. Indeed, Bernanke’s White House experience, whatever its worth, will be slim, measured in months, perhaps only weeks, before Bush decides on a name.
“You start squeezing the time when [Bernanke] could develop that loyalty, familiarity with the Bush crowd,” Alan Blinder, a former Fed vice-chairman and current University economics professor, says via the Daily Princetonian. “How that works out remains to be seen. What’s changed since February is that there are two months less during the time when [he] can develop that relationship.”
If Bernanke, who co-authored last year’s book The Inflation-Targeting Debate, ultimately makes the grade, it’s all but certain that he’d push for adopting such a rule at the Fed. “As you may know, I have advocated for stronger measures [at the Fed] such as adopting an inflation target or more explicit objectives,” Bernanke recently said at a student symposium at the University of Dayton, reports Reuters.
Inflation targeting, on the surface at least, seems a timely policy that’s ripe for embrace. With Greenspan’s tenure winding down, the question of who can fill his shoes is increasingly a topical and challenging subject in Washington and Wall Street. Whether you love or hate the current Fed chairman, it’s clear that replacing his influence and broad respect in the markets is going to be tough, if not impossible, at least initially. Minds differ over whether that’s good or bad for the U.S. economy and the stock and bond markets, but no one has any illusion that a new Greenspan is poised to take over.
Does that mean that a mechanical inflation targeting system is a policy whose time has come? With inflationary pressures mounting, the stakes are clearly rising. As such, inflation targeting’s time has come, say the policy’s supporters. Replacing Greenspan’s brand of recondite means of managing interest rates with a more transparent policy would represent progress, goes this line of thinking.
The empirical evidence speaks for itself, say inflation targeting’s promoters, who argue that such a rule would give the bond market greater confidence by taking much of the guesswork out of central banking, and in turn, that would persuade investors to accept lower yields.
The empirical record that inflation targeting works starts with the European Central Bank, which uses a target and boasts of a lower inflation rate compared with the United States. The two, we’re told, are no accident. Indeed, the consumer price index in America is advancing at a 3.0% annualized rate, as of February. The comparable figure a 1.6% rate of inflation each for France and Germany, the two largest euro economies.
Critics respond that inflation has generally been coming down in America and elsewhere for 20 years (until recently, that is), and without the aid of an inflation target. What’s more, the U.S. economy is growing at a faster clip, rising by 3.9% at a real (inflation-adjusted) annualized pace, based on last year’s fourth quarter GDP report. France compares with a 2.3% rise in GDP, based on 2004’s fourth quarter, and Germany’s barely growing at all with a 0.6% rate of increase.
Critics of inflation targeting wonder too if handing over some or all of the Fed’s current freedom to act as it sees fit in the business of setting interest rates is short-sighted. Financial emergencies, such as the fallout from Long Term Capital Management or the 1987 stock market crash, need a Fed that’s flexible enough to step in an flood the system with liquidity that would otherwise be imprudent. And that, goes the argument, requires wet-ware in the form of a living, breathing Fed chairman, albeit one who has the talent for enlightened and timely decisions.
In fact, stepping in to deliver financial balm in the wake of Wall Street’s greatest crash is just what Greenspan did in 1987, just a few months after he became chairman. As E. Gerald Corrigan, president of the New York Fed, told Greenspan on October 19, 1987, a day when the Dow Jones Industrials shed 22.6% in a single trading session, “Goddammit, it’s up to you. This whole thing is on your shoulders.”
But while the maestro opened up the monetary spigots that day, there are questions if something comparable is possible if the central bank is being run by something akin to auto pilot, otherwise known as inflation targeting. Not to worry, say advocates of a mechanical inflation-targeting rule. In fact, one member of the Shadow Open Market Committee tells CS that it’s all a matter of design. There’s no reason, he explains, that an inflation target can’t be flexible in the short term to address any and all financial emergencies. How so? For instance, an inflation target could be measured by average results over, say, two or three years. That way, in the short run, the Fed would be free to do what it feels is necessary and still have time to pick up the slack to meet the long-run target.
Of course, no one really knows how a targeting regime would work in the U.S. for the simple reason that it hasn’t yet been tried. Well, that’s not completely true. Perhaps there’s something to be learned from the gold standard? Tying the money supply to gold was in fact a form of inflation targeting. What’s more, it worked. Maybe it worked too good. The problem with a gold standard is that its inherent inflation-containing rules eventually create pressures to do the “right” thing, monetary wise—pressures that become unbearable in political terms. That’s why President Franklin Roosevelt and other pols through history have felt compelled to quit the gold standard.
Would an inflation target suffer any less pressure at some point to sacrifice longer-term integrity of the dollar for shorter-term political gain? Indeed, the Fed’s twin mandate of protecting the dollar and maximizing employment hint at the Faustian financial bargain that inevitably awaits.
Perhaps there’s a kernel of insight on the subject from Bernanke himself. In a speech on March 30, he explained that among the Fed’s primary tools for successful monetary management is influencing long-term interest rates, which are set by the market. Indirectly, the central bank moves long-term rates by controlling short term rates via money supply. But in the end, talk is second to none when it comes to moving long rates, Bernanke concluded, reminding, “The most direct method is through talk.” He went on to note,
The FOMC’s post-meeting statement, the minutes released three weeks after the meeting, and speeches and congressional testimony by the Chairman and other Federal Reserve officials all provide information to the markets and the public about the near-term economic outlook, the risks to that outlook, and the appropriate course for monetary policy. With the aid of this information, financial market participants make estimates of the likely future path of short-term interest rates, which in turn helps them to price longer-term bonds. FOMC talk probably has the greatest influence on expectations of short-term rates a year or so into the future, as beyond that point the FOMC has very little, if any, advantage over market participants in forecasting the economy or even its own policy actions.
But would the influence of rhetoric be minimized, if not dispensed altogether, under an inflation-targeting regime? Bernanke, presumably, wants to know, being no amateur when it comes to deploying Fed talk with the goal of moving markets and changing investor perceptions. It was, after all, Fed Governor Bernanke who, in a widely quoted 2002 speech on the subject of fighting deflation, made a cheeky reference to the fact that the central had a printing press and was willing to use it in adjusting the money supply. Inflation, in other words, could be created at will, Bernanke reminded, and the sky, in theory, was the limit. Tough talk, and well advised, he reasoned, since deflation was considered Public Monetary Enemy No. 1 at the time.
Would such talk be banished under a Bernanke regime? Would it matter? Inquiring bond investors would like to know.