Wednesday, November 16, 2005

Bernanke's confirmation testimony 

Ben Bernanke is not shying away from an open discussion of inflation targeting. In his testimony yesterday he offered a vision of how IT would augment the gains in disinflation made by Greenspan:
...under Chairman Greenspan, monetary policy has become increasingly transparent to the public and the financial markets, a trend that I strongly support. A more transparent policy process increases democratic accountability, promotes constructive dialogue between policymakers and informed outsiders, reduces uncertainty in financial markets, and helps to anchor the public's expectations of long-run inflation--which, as I have argued already, promotes economic growth and stability.

One possible step toward greater transparency would be for the FOMC to state explicitly the numerical inflation rate or range of inflation rates it considers to be consistent with the goal of long-term price stability, a practice currently employed by many of the world's central banks. I have supported this idea in my academic writings and in speeches as a Board member. Providing quantitative guidance about the meaning of "long-term price stability" could have several advantages, including further reducing public uncertainty about monetary policy and anchoring long-term inflation expectations even more effectively.

I view the explicit statement of a long-run inflation objective as fully consistent with the Federal Reserve's current policy approach, including its appropriate emphasis on the role of judgment and flexibility in policymaking. Most important, this step would in no way reduce the importance of maximum employment as a policy goal. Indeed, a key justification for this action is its potential to contribute to stronger and more stable employment growth by further stabilizing inflation and inflation expectations. In any case, I assure this Committee that, if I am confirmed, I will take no precipitate steps in the direction of quantifying the definition of long-run price stability. This matter requires further study at the Federal Reserve as well as extensive discussion and consultation. I would propose further action only if a consensus can be developed that taking such a step would further enhance the ability of the FOMC to satisfy its dual mandate of achieving both stable prices and maximum sustainable employment.

This is a bigger deal than you may realize. It certainly makes Congress nervous, as noted by Senator Richard Shelby, saying he wants to have the Fed pay attention to both mandates. Bernanke assures him that the Fed would continue to do so. But the purpose of IT is to make price stability the first goal. Now, unlike New Zealand or other countries that put their central bank chiefs on a performance contract -- hit the target or you're fired -- the vision Bernanke doesn't act as binding on the Fed's behavior. He noted in questions later, for instance, that he would not be tied to the actual inflation rate but the path of expected inflation.

Responding to a question about a hypothetical rise in inflation in 2007: "My principal concern at that point would not be that inflation had temporarily risen above its normal range -- for example current inflation is above the range that in the long run would be desirable. But the concern would be that expectations about inflation going a year or two into the future had become unhinged or unanchored."

You could always claim that you are not responding to current inflation because your forecast of expected inflation indicates return to the target rate. And the Fed's independence means that it's the last arbiter of these things. But Bernanke is arguing for this as a way of reducing uncertainty about Fed behavior.

In 2003, there was an episode where there was clearly miscommunication between the Federal Reserve and the bond markets and it caused a significant fluctuation in the bond markets. It was over the issue of whether or not there was some risk of deflation coming forward.

"Clearly there was a misunderstanding about that risk.

"It impressed on me the importance of speaking clearly and communicating clearly and making sure there was understanding on both sides about what the Fed is saying and what the Fed is intending to do."

We had a communications official from the New York Fed here a couple of years ago -- I can't remember if it was late 2003 or early 2004 -- and it was obvious to me that at least there, where the system open market desk is tasked with the daily conduct of monetary policy, communications was being re-thought due to misperceptions in the bond market. (See contemporary stories here and here.) They argued that the Fed had something to do with this behavior:

There seems little doubt, based on the reading, that Bernanke will be confirmed by a large margin. That's why the hearings are not getting news ... well, that and the Senate's behavior. A few years from now, though, this might be the more meaningful change.

UPDATE: New Economist points out this review of the literature on inflation targeting. It's pretty throrough.