The 2011 decision to stick with inflation targeting doomed America to a decade of rock-bottom interest rates
By R.A. | LONDON
BEN BERNANKE'S book is officially out and available. The Economist's full review will be published later this week (it's a big book). But debate about the book's arguments is already unfolding, and I can't resist joining in.
Two weeks ago, The Economistrepeated its endorsement of a change in the Fed's monetary policy target, from an inflation rate to a growth rate for nominal GDP (NGDP): or total spending and income in an economy in dollar terms. In November of 2011, during Mr Bernanke's chairmanship of the Fed, the monetary-policy committee considered a change to an NGDP target, but opted to stay with the old, inflation-focused framework. Mr Bernanke writes:
For nominal GDP targeting to work, it had to be credible. That is, people would have to be convinced that the Fed, after spending most of the 1980s and 1990s trying to quash inflation, had suddenly decided it was willing to tolerate higher inflation, possibly for many years.
And so in January of 2012 the Fed reiterated its inflation-targeting stance and officially designated a 2% rate of inflation, as measured by the price index for personal consumption expenditures, as the target.
We all know what happened next. Since then, the Fed has spectacularly undershot its inflation target. In 2011, most Fed members thought that interest rates would begin to rise in 2014 and would end the year at about 0.75%—and most thought rates would eventually settle at a level between 4-5%. Now, markets suspect rates might not rise to 0.5% until well into 2016, and most Fed members think rates will never get any higher than 3.5%. Treasury prices suggest that inflation will be closer to 1% than 2% over the next five years.
There is good reason to believe that Mr Bernanke's Fed made a big mistake, in other words. An NGDP target would have worked out better, in two key ways.
First, a switch to an NGDP target would have helped the Fed choose policy more appropriately at a tricky time in the recovery. In 2011 high oil prices drove headline inflation above 2%, despite significant weakness in core inflation, in wage growth, and in the labour market. In early 2012, at the time the Fed was adopting its inflation target, the central bank sensibly shrugged aside calls to raise rates in response to rising prices. Yet it also took no additional action to boost the economy. The recovery subsequently lost pace, inflation fell, and by the end of 2012 the Fed was forced to restart QE. Had the Fed instead focused its attention on NGDP, it would have been forced to react to an economy that was well below an appropriate level of output and which was growing too slowly. The Fed could have looked straight through inflation and kept its foot on the accelerator. Instead it took the costly choice to dither.
Just as importantly, a switch to an NGDP target would have sent a strong signal about Fed priorities, precisely because it was a significant departure from past policy-making. Mr Bernanke notes that the Fed spent the 1980s and 1990s trying to quash inflation. It did not arrive at that policy strategy passively; on the contrary, that strategy was a bold departure from what had come before. Paul Volcker might have argued in the early 1980s that the Fed couldn't possibly rein in double-digit inflation because it lacked credibility as an inflation-fighter after a decade of neglecting the problem. Instead, he used the tools available to him to demonstrate the Fed's credibility.
Mr Bernanke's Fed could have, and should have, taken similarly bold action. It could have set a bold and more effective target and committed itself to unlimited asset purchases until that target was hit. Instead, it made itself a prisoner of its own complacency. As a result, inflation and interest rates will spend most of the 2010s at dangerously low levels, leaving the American economy disconcertingly vulnerable to new economic shocks.
The book, by the way, is titled "The Courage to Act".
