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Is Criticism of the Bernanke Fed Justified?

Ben Bernanke's term as Chairman of the Federal reserve ends in January. He has been nominated by the president for reappointment, but reappointment must be approved by the Senate. The first step in the approval process came last week when the Senate Banking Committee voted 16-7 to send his nomination to the full Senate.

While I expect Bernanke will be reappointed, there is growing opposition from three groups, all of which are concerned about the Fed's commitment to fight inflation. The first group is libertarians such as Ron Paul:

Throughout its nearly 100-year history, the Federal Reserve has presided over the near-complete destruction of the United States dollar. Since 1913 the dollar has lost over 95% of its purchasing power, aided and abetted by the Federal Reserve's loose monetary policy. How long will we as a Congress stand idly by while hard-working Americans see their savings eaten away by inflation?
If he could, he'd abolish the Fed entirely. The second group is the financial community as exemplified by this recent WSJ editorial:
The Fed chairman has shown he knows how to ease money, and creatively so. But that is the easy part of his job. The hard part, the time when central bankers earn their fame, is when they have to take the money away. We see little in the chairman's policy history or guideposts to suggest he will be willing to endure the criticism that will come with tightening money amid a lackluster recovery, if that is what is required to protect the dollar or prevent an inflation outbreak.
So the libertarians and the financial community are both worried that the Bernanke Fed will not be aggressive enough in its fight against inflation. That is in contrast to the third group that opposes Bernanke, the populists. This group is worried that the Fed will pay too much attention to inflation:
Bernanke acknowledges that a higher inflation target would stimulate "spending and output," which leads to economic growth. But he then says that he cannot do so, because of the threat that setting a higher inflation target might lead to higher inflation than that down the road. In other words, the threat of inflation is more crucial than the reality of double-digit unemployment.
So two groups opposed to Bernanke's reappointment are worried he won't devote enough attention to fighting inflation, and the third group is worried inflation is too much of a priority. These groups appear to be reinforcing rather than canceling each other politically even though they are upset about opposite things.

Why does the Fed care about inflation at all? It is not immediately apparent why central banks around the world have a nearly universal emphasis on maintaining a low and stable inflation rate. What does this have to do with consumer welfare? Consumer utility is a function of goods and services, not prices, so why does the Fed care about inflation?

In New Keynesian macroeconomic models that are used to evaluate monetary policy rules, sticky prices are the source of output fluctuations. When some prices are sticky while others are flexible in the presence of inflation, the relative prices between goods will be distorted since some prices cannot respond immediately to offset shocks. These distortions cause resources to flow to the wrong sectors in the economy, and this causes the production of the wrong mix of goods relative to societal preferences. And when the sticky prices do finally adjust, these distortions must be undone through resources moving back out of the sector, and this causes higher unemployment during the adjustment period.

The point is that inflation can cause distortions in the production of goods and services and reduce employment, both of which reduce household utility. When the Fed lowers inflation, there are fewer distortions, a better mix of goods and services is produced, and employment will be higher.

So, theoretically at least, targeting inflation can help households. Because of this, I do not believe for a minute that Ben Bernanke is taking the side of Wall Street over Main Street when he talks about the need to keep inflation under control. He believes that stabilizing inflation leads to higher employment, a better mix of goods, and higher household welfare. In addition, theory tells him that maximizing household welfare means responding more aggressively to inflation shocks than to output shocks. In particular, the Taylor rule coefficients imply the Fed should increase the federal funds rate by one-half percent when output deviates by one percent from target, but increase the federal funds rate three times as much, by a point and a half, in response to a one percent inflation shock.

There are two questions here. First, is the rule the Fed follows of responding three times as aggressively to a one percent inflation shock as compared to a one percent output shock optimal (note that many other central banks are pure inflation targeters, they only respond to deviations of inflation from target, output and employment deviations are ignored)? Second, is the standard Taylor rule type policy appropriate for severe recessions?

The answers to the two questions are related. In normal times, i.e. when fluctuations in the economy are moderate and driven by something other than a severe banking crisis, I think the Taylor rule prescription works fairly well. There is certainly room to fiddle with the inflation and output coefficients in the Taylor rule, responding three times as aggressively to inflation is not optimal in all models and further research may adjust those proportions. But the basic notion of responding to both inflation and output deviations seems reasonable if, in fact, price stickiness is the source of the fluctuations in the economy. I cannot fault Bernanke and the Fed for following this prescription during normal times.

However, while I'm willing to accept that sticky prices are associated with normal types of fluctuations in the economy, I find it hard to believe that the current crisis can be modeled in this way. The fluctuations we are seeing are not fundamentally driven by price rigidities of the type embedded in the New Keynesian model (or by price rigidities of any type for that matter). Because of this, policy rules derived from sluggishly price adjustment models are inapplicable. The Fed should not be using arguments based upon this model, arguments embedded in the Taylor rule, to justify keeping inflation low during the recovery period. That may be the right policy, but the New Keynesian sluggish price adjustment model cannot be used to justify it.

What model should we use? That is the problem, we don't have a well-accepted model to use when there is a financial crisis like we are experiencing, one where the financial sector breaks down and causes problems for both Wall Street and Main Street. We have some notions of what models to use, and those calling for quantitative easing (i.e. a higher inflation target than the Fed is willing to shoot for) are using these rudimentary models to inform their policy recommendations. But it's hard for me to have much confidence in what these models say given their relatively primitive nature.

Thus, in my view, the Fed is largely flying blind right now. It does not have the models it needs to truly understand what policy approach is best in the present environment. I have not been a strong advocate of quantitative easing, i.e. targeting, say, a 3 percent inflation rate, but I cannot claim that my view is informed by a theoretical model of the crisis I believe in, such a model does not yet exist. My view is based on empirical evidence suggesting the relative impotency of monetary policy in recessions, but that evidence comes from regular recessions, not a severe recession like we are having now and the evidence may not apply. Because of this, i.e. because of the considerable uncertainty over what policy is best, I have emphasized a portfolio approach involving both monetary and fiscal policy in the hopes that one or the other will get the job done. My concern lately is that all the talk about Bernanke and the Fed has distracted our attention away from fiscal policy, but perhaps another stimulus package isn't politically viable in any case. But as I've said before, that doesn't mean I will give up pushing this point - I believe fiscal, not monetary policy, is the best response right now.

For those who are making strong statements about what policy should be, and beating up Bernanke and the Fed for not following those policies, I ask you to do one thing: Produce a theoretical model that can explain the crisis and justify your policy response. It's certainly possible to start with, say, a liquidity trap and move on from there to justify quantitative easing, but if the liquidity trap arises in a New Keynesian sluggish price adjustment model, or some other model that does not capture the essence of this particular crisis, should we take it seriously? There are some models that can justify quantitative easing, but I don't think those models fully capture the factors that caused this particular crisis. It's very good to ask these questions, and perhaps quantitative easing is, in fact, the way forward, but until we have better models, we just don't know for sure.

Still, even though there are uncertainties about the best way to proceed, the employment problem is big enough to justify a wide spectrum, aggressive approach. Thus, while I do worry about our ability to undo quantitative easing later without causing an inflation problem -- something that would be a big blow to employment down the road -- and while I'm not convinced quantitative easing will do much to generate new output and jobs right now, we should try everything that has a reasonable chance of working. That means quantitative easing, new spending on infrastructure, tax cuts to encourage investment and hiring, make work programs, whatever it takes to get both the economy and people working again.

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