Bernanke Loosens Up

When Ben Bernanke came in as head of the Federal Reserve, many predicted that he would bring a more systematic approach to inflation management than Alan Greenspan had used. The word on the new Fed chief was that he would use an inflation centric focus in contrast to Greenspan's more flexible price stability focus.

At the time, the news kind of worried me. First, the story of the Federal Reserve is one about change. Greenspan was effective because he demonstrated the ability to learn from past mistakes and react to new and different challenges. The idea that the new chief might be wedded to strict models seemed risky. Some argued that the markets would react positively to a more rules based Fed management style. But I was unsure.

Further, it seemed to me that too great a concentration on the traditional predictors of inflation could well slow growth. Although inflation management is central to monetary policy, it is really price stability that should be the primary goal. Unemployment is one of the key data points used in managing inflation, but it is increasing difficult to determine. As more and more people are self-employed, or working in non-corporate jobs, there has been a widening gap between the "household" numbers and the more traditional unemployment figures derived from corporate surveys. Additionally, the impact of global business on the US inflation picture increases as our economy increasingly integrates with other major economies.

So it was with some relief that I read this article in Tech Central Daily. It is reported that Bernanke is lowering his reliance on unemployment figures in his predictive models of inflation. With increased globalization and higher worker productivity (think technology), Bernanke appears to be making the argument that it takes increasingly larger reductions in unemployment to generate the inflation it did twenty years ago. As such, Fed will have a greater tolerance for low unemployment figures before putting the screws on the money supply.

I think this is a good move and could well provide a nice boost to growth over the long term. If the Fed maintains freer money even in the face of low unemployment, the obvious result will be higher earnings and higher growth. It remains to be seen if this will have the desired impact. But when it comes to the Fed, small incremental change based on considered analysis is usually a good thing.

3 comments:

JP

9:01 PM

Jake, interesting reading on inflation in today's WSJ letters-to-the-editor page, A5. The author's premise is that inflation has been wrung out of every industry except three, where we lack market-driven system -- education, healthcare, and energy...

JP

9:06 PM

And this, a different perspective, from my long-time hero, Steve Forbes:

Bronx Cheers for Ben

On the occasion of his first anniversary as Federal Reserve Chairman in February, Ben Bernanke was saluted by Wall Street and most of the business media for controlling inflation. The celebration, alas, was painfully premature. The inflation set off by Alan Greenspan's mistaken monetary extravagance in 2004 has not been fixed by his successor. The Fed's excess money creation is still roiling and distorting economies and financial markets around the world. The destructive political repercussions are unfolding.

The most notorious symptom of the Greenspan-Bernanke blunder is the still high price of oil. But, of course, the monetary extravagance fired up commodities across the board--all the major ones are significantly higher than they were three years ago.

Commodities are the first to feel monetary mistakes. The best barometer of these, historically, has been the price of gold. In 2004 its rolling ten-year average was under $350 an ounce. Today it's up more than 80% from that level, hovering between $625 and $700 an ounce.

Remember that famous quote by John Maynard Keynes: "There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

The latest debauching of the currency is indeed being misdiagnosed by almost everyone. Higher oil and gasoline prices are blamed on greedy oil companies and the voracious consumption of India and China. These two countries are also blamed for sending other commodities into the stratosphere. The Fed's culpability has been ignored. Anyway, observers say, increases in the cost of living are still small and therefore not anything to worry about.

But inflation indexes are seriously flawed. The faulty methodologies in the way they're put together, such as underplaying improvements in products and services and the crazy way in which we measure housing, have long been noted. The indexes are rearview-mirror measures. If the Fed messes up, it takes a year or two for the mistake to become apparent in the broader economy. Moreover, given the extraordinary increases in productivity, the general price level, if anything, should be going down.

Nor are the various money supply numbers all that helpful. A dollar created by the Fed can, in effect, be multiplied several hundredfold around the world, thanks to a bewildering array of financial instruments that permit mind-boggling layers of leveraging.

Before becoming Fed head, Ben Bernanke wrote papers about "excess" savings worldwide: People aren't spending and investing enough, and that's why global financial systems are awash in cash. Alas, those excess savings are a euphemism for excess money creation by central banks, particularly the Federal Reserve.

The Greenspan-Bernanke mistake has already increased short-term interest rates nearly fivefold since 2004. It overheated the housing market, now undergoing a painful correction. It induced lenders to extend credit overeagerly, overgenerously to "subprime" borrowers. It fanned the hothouse growth of hedge and equity funds. It shattered GM, Ford and DaimlerChrysler (nyse: DCX - news - people ) by shooting up gas prices, which cratered sales of their high-margin SUVs. The artificial oil boom has given the criminal regimes of Iran and Venezuela lethally large cash windfalls to stoke terrorism. It has also loosed a gusher of government subsidies for "alternative energies"--most of which will be unviable.

Before year's end the Fed will probably raise short-term interest rates again. But, as the 1970s and early 1980s agonizingly demonstrated, increasing the nominal cost of money does not necessarily undo the debauching of the dollar. Mopping up excess greenies, which the Fed could do by selling some of the government bonds it holds in its portfolio, will cure the disease--quickly, too. Otherwise, major defaults from excess debts may destructively extinguish some of the excess money.

Jake

9:29 PM

"But inflation indexes are seriously flawed. The faulty methodologies in the way they're put together, such as underplaying improvements in products and services and the crazy way in which we measure housing, have long been noted. The indexes are rearview-mirror measures. If the Fed messes up, it takes a year or two for the mistake to become apparent in the broader economy. Moreover, given the extraordinary increases in productivity, the general price level, if anything, should be going down."

This is what worried me when Bernanke came in. It looked to me from the TCS article that he was rethinking his inflation model driven approach and looking more like Greenspan. But maybe I read it wrong.

I know you are a big fan of Forbes as am I. Sometimes he seems to be overly focused on commodity pricing and hard currency. But I too would lean that way.

He seems to pin an awful lot on high M1 growth. Blaming Detroit's woes on money supply growth seems like a bridge too far. But if he is right, he is also right to say that all this could be remedied quickly.

RE the WSJ article, that sound like a good point to me. I do think that inflation is under control in the competitive economy. Clearly it is not in education and healthcare, where productivity increases are a long way off. Given that politics controls those sectors, I have little hope for them. It would seem they will have to get a lot worse before they get blown up and we start over with school choice and mandated private health insurance. With the 2008 lineup, that could take a while.