Monday, October 24, 2005

Bernanke, inflation and targeting 

Should we make any big deal of the fact that the bond market sold off today, with Ben Bernanke replacing Alan Greenspan at the Fed? No, because looking at the inflation-indexed bond market shows that both indexed and non-indexed bonds fell by roughly the same amount. Were the concern about Bernanke that he would be softer on inflation, the non-indexed bond should have fallen more than the indexed bond. That link also includes a reminder that the bond market sold off when Alan Greenspan replaced Paul Volcker in 1987.

There was similar nervousness in the early months of 1987, as investors, analysts and other market participants realized that Volcker's term as chairman would expire in August, [economist Stuart] Hoffman recalled. It was unknown early in the year whether Volcker wanted a third term or if President Reagan wanted him to stay. Volcker had been chairman since August 1979, and was credited with leading the Fed drive that ended double-digit inflation.

"There was talk in the markets" about whether Volcker would leave, and some apprehension at the thought that "this guy, who since '79 had guided them through a lot of turmoil, would be leaving and someone new would be coming in," Hoffman said.

Everyone wants things to stay as they are with monetary policy, and the market prices uncertainty by asking for a higher real yield. Thus today's bond market.

So what would a Bernanke presidency do? The economists discussing Bernanke on the WSJ public econoblogger are generally upbeat; Mark Thoma is concerned that Bernanke will not speak with as much authority as Greenspan about budget deficits. It's worth remembering that Greenspan didn't do much of that either through the Bush 41 presidency -- his deficit hawkishness was also made effective by his interaction with Bob Rubin in influencing the first Clinton presidency. Having heard Bernanke speak more than a few times (including a visit here to SCSU a couple of years ago) I believe he'll grow into that role just fine. Given that, I believe, he is taking the next Greenspan term, he'll have potentially fourteen years to grow.

Much is made about his views on inflation targeting, the strategy of operating monetary policy with direct reference to a goal for the inflation rate. On this, I think Nouriel Roubini makes an excellent point.
[Bernanke] will have to move carefully as any attempt to formally change the framework of US monetary policy towards "inflation targeting" may lead Congress to try to interfere and impose politically damaging conditions on monetary policy: for example, Congress may argue that, if we move to a formal inflation target, we should also have a formal "high GDP growth" target, a political interference that would undermine the appropriate conduct and flexibility of monetary policy. So, I am not sure that inflation targeting will ever be adopted by the Fed, even during a Bernanke Chairmanship, as such a move would be fraught with many congressional interference obstacles. More likely, the Fed, like it is doing now will make its inflation forecast - an implicit inflation target - even more explicit to the public as an indirect
signaling of an implicit - but not formally explicit - inflation target.

This indirect signal has been there for years. Marvin Goodfriend (NBER paper #9981 subscribers link -- I haven't found an unprotected version of this paper) reminded us a couple years ago that Alan Greenspan made a qualitative case for an inflation target as early as 1989, when he said to Congress he wanted an inflation rate such that "the expected rate of change of the general level of prices ceases to be a factor in individual and business decisionmaking." Whether that's zero, one, or two percent is a debate worth having, and it appears that the Fed has been debating it. Chicago Fed President Michael Moskow said a few weeks ago that the issue was as much to do with communication as anything. That is likely to be the thinking for awhile -- there isn't an exact number that works, there isn't agreement about which measure of inflation you use, there isn't an easy way to say which shocks you'd tolerate and which you wouldn't.

I'm working on a couple of papers on inflation targeting in transition economies right now, and I would add one more thing to this -- what typically is meant by inflation targeting, particularly when Bernanke discusses it, is really inflation forecast targeting. That is, you are not going to determine policy by what has happened in the past to some measure of inflation, but you are going to forecast inflation explicitly, compare it to some reference of what is a good rate, and then announce how policy moves you from the forecast rate towards the good rate if those aren't the same. (See, for example, the discussion on page two of this article by Ben McCallum, discussing Goodfriend.) And here is where Roubini's point is excellent -- can you imagine this discussion of inflation forecasts occurring during Humphrey-Hawkins testimony before the Senate Banking Committee? Econometrics and Chuck Schumer don't mix.

As Goodfriend argues, though, it's as if we've already had inflation targeting; it's hard to believe Greenspan could evoke a rule like that in 1989 without having the Fed aim at a rate like this. Was it the only Fed goal? Certainly not, but the "measured pace" language of Federal Reserve directives to its operations desk (which provides the guidance for daily operation of monetary policy) has contained sufficient reference to inflation to act as an informal guide. And some within the Fed, like William Poole, have been uncomfortable with even that amount of hand-tying, of which more would come with more formal rules. I suspect, in the final analysis, the discussion of inflation targeting in the U.S. will remain academic.