Watching as the Federal Reserve juggles priceless eggs in variable gravity…

Is it necessary to say that we hold Ben Bernanke, Mervyn King, Mark Carney, Janet Yellen, Stan Fischer, Lael Brainard, and company to the highest of high standards–demand from them constant triple aerial somersaults on the trapeze–because we have the greatest respect for and confidence in them? It probably is…

Back in 1992 Larry Summers and I wrote that pushing the target inflation rate from 5% down to 2% was a very dubious and hazardous enterprise because the zero-lower bound was potentially a big deal: “The relaxation of monetary policy seen over the past three years in the United States would have been arithmetically impossible had inflation and nominal interest rates both been three percentage points lower in 1989. Thus a more vigorous policy of reducing inflation to zero in the mid-1980s might have led to a recent recession much more severe than we have in fact seen…”

This does seem, in retrospect, to have been quite possibly the smartest and most foresightful thing I have ever written. Future historians will, I think, have a very difficult time explaining how the cult of 2%/year inflation targeting got itself established in the 1990s. And they will, I think, have an even harder time explaining why the first monetary policymaker reaction to 2008-2012 was not to endorse Olivier Blanchard et al.’s call for a higher, 4%/year, inflation target in the coded terms of IMF speak:

The great moderation (Gali and Gambetti 2009) lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment….

The crisis has shown that large adverse shocks do happen. Should policymakers aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? Are the net costs of inflation much higher at, say, 4% than at 2%, the current target range? Is it more difficult to anchor expectations at 4% than at 2%? Achieving low inflation through central bank independence has been a historic accomplishment. Thus, answering these questions implies carefully revisiting the benefits and costs of inflation.

A related question is whether, when the inflation rate becomes very low, policymakers should err on the side of a more lax monetary policy, so as to minimize the likelihood of deflation, even if this means incurring the risk of higher inflation in the event of an unexpectedly strong pickup in demand. This issue, which was on the mind of the Fed in the early 2000s, is one we must return to…

But instead we got a very different reaction. Sudeep Reddy reported on it back in 2009:

Sudeep Reddy (2009): Sen. Vitter Presents End-of-Term Exam For Bernanke: “Earlier this month, Real Time Economics presented questions from several economists…

…for the confirmation hearing of Federal Reserve Chairman Ben Bernanke…. Sen. David Vitter (R., La.) submitted them in writing and received the responses from Bernanke….

D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?

[Bernanke:] The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations.

In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.

The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

This sounds like nothing so much as the explanations offered in the 1920s and 1930s for returning to and sticking with the gold standard at pre-WWI parities, and the explanations offered at the start of the 1990s by British Tories for sticking to the fixed parities of the then-Exchange Rate Mechanism. The short answer is that real useful positive credibility is not built by attempts to stick to policies that are in the long run destructive–and hence both incredible and stupid. As we learn more about the economy and as the structure of the economy changes, the optimal long-run policy strategy changes as well. Credibility arising from a commitment that the Federal Reserve will seek to follow an optimal long-run policy framework and to accurately convey its intentions but will revise that framework in light of knowledge and events is worth gaining and maintaining. Credibility arising from a commitment to stick, come hell or high water, to a number that Alan Greenspan essentially pulled out of the air with next to no substantive analytical backing in terms of optimal-control analysis is not.

Now, however, we have another answer from Janet Yellen: that the zero lower bound is not, in fact, such a big deal:

Janet Yellen: The Outlook, Uncertainty, and Monetary Policy: “One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment…

…Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.10 While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Over on the Twitter Machine, the very-sharp Tim Duy–I take it from his picture that there is ample snowpack for the ski resorts in the Cascade Range–is impressed by how different the tone of this speech is with the get-ready-for-liftoff speeches of last fall:

And Dario Perkins and Mark Grady have chimed in in support: “suddenly she’s realised the rest of the world matters!…” and “lots of common messages, but emphasis v[ery] diff[erent] on the risks. And no mention of lags or falling behind the curve at all…”

I, by contrast, am still struck by the gap that remains between where she seems to be and where I am.

For there is a natural next set of questions to ask anyone who says that the zero lower bound and the liquidity trap are not big deals. That set is:

  • Then why isn’t nominal GDP on its pre-2008 trend growth path?

  • Why is the five-year ahead five-year market inflation outlook so pessimistic?

  • Why hasn’t the Federal Reserve pushed interest rates low enough so that investment as a whole counterbalances the collapse in government purchases we have seen since 2010?

Gross Domestic Product FRED St Louis Fed Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed FRED Graph FRED St Louis Fed

I cannot help but be struck by the difference between what I see as the attitude of the current Federal Reserve, anxious not to do anything to endanger its “credibility”, and the Greenspan Fed of the late 1990s, which assumed that it had credibility and that because it had credibility it was free to experiment with policies that seemed likely to be optimal in the moment precisely because markets understood its long-term objective function and trusted it, and hence would not take short-run policy moves as indicative of long-run policy instability. There is a sense in which credibility is like a gold reserve: It is there to be drawn on and used in emergencies. The gold standard collapsed into the Great Depression in the 1930s in large part because both the Bank of France and the Federal Reserve believed that their gold reserves should never decline, but always either stay stable of increase.

It was Mark Twain who said that although history does not repeat itself, it does rhyme. The extent to which this is true was brought home to me recently by Barry Eichengreen’s excellent Hall of Mirrors

I tell you, I have a brand new set of lectures to write for a large monetary-policy module in American Economic History…

March 30, 2016


Brad DeLong
Connect with us!

Explore the Equitable Growth network of experts around the country and get answers to today's most pressing questions!

Get in Touch