Bernanke's Speech: A Big Tease

Ben Bernanke delivered a much anticipated speech today at the Jackson Hole Economic Symposium.  Many observers, myself included, were wondering if he would advocate a more aggressive role for monetary policy given the signs of weakening in the U.S. economy.  Instead, what he delivered was a big tease: he acknowledges three points made by advocates of more monetary easing, but then either ignores the implications of these points or argues against them.

Let's look at the three points he acknowledges in turn.  First, he concedes that the low interest rates can reflect a weak economy rather than being a sign of loose monetary policy.  Second, he grants that the Fed can be effectively tightening monetary policy simply by being passive.  He makes these two big concessions in his discussion of why the FOMC decided to stabilize the Fed's balance sheet (my bold):

[A]llowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome.

Consider the implications of these points.  First, if lower interest rates reflect economic weakness--though he mentions long-term interest rates recall they are the expectation of a bunch of short-term interest rates plus some term premium--then one implication is that the low federal funds rate may not be so accommodative after all. Given the state of the economy, maybe the 0%-0.25% range for the federal funds rate is not low enough.  Now the federal funds rate cannot go negative (and this is one of the problems with using an interest rate target), but if it could the implication here is that it may need to go deep into negative territory in order to be at the appropriate level.  Folks like Andy Harless and Glenn Rudebusch have made this very point. So what does Bernanke think? Does he run with his own argument to its logical conclusion?   The answer is no. Elsewhere in the speech he claims that "monetary policy remains very accommodative" and that the "Fed has also taken extraordinary measures to ease monetary and financial conditions. Notably,... the FOMC has held its target for the federal funds rate in a range of 0 to 25 basis points..." In short, Bernanke thinks the low federal funds rate is sufficiently accommodative, even after acknowledging that low interest rates can reflect weak economic conditions rather than loose monetary policy.

Now consider his second concession: the Fed can effectively be tightening monetary policy just by being passive.  He acknowledges this point in the context of stabilizing the Fed's balance sheet.  This is an important insight, but what about the other ways the Fed can passively tighten monetary policy? Currently, the Fed is failing to stabilize the NGDP or aggregate demand forecast. By allowing this to happen the Fed is effectively tightening monetary policy.  Why is he not concerned here too about such passive tightening of monetary policy?

Bernanke's third concession is an important one too. In his discussion of what the Fed can do if more action is required, he alludes to the idea of price level targeting. Now this option is not as good as NGDP level targeting, but it would be vast improvement over what is going on. Here is what he said:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability... in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

He is absolutely right that a price level target would mean higher than normal inflation currently to get the economy back to its previous price level path.  If such a price level target were formally announced, it would go a long ways in (1) creating more economic certainty  and (2) helping household balance sheets repair themselves. So is Bernanke on board? Unfortunately, for two reasons the answer is no. First, he sees no support for such a policy in the FOMC .  And, apparently, this is one battle he does not want to fight at the Fed.  Second, and more troubling, he does not think it is needed and believes it could even be problematic:

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy

 This is perplexing on so many levels. First, an explicit price level target would not destroy long-run inflation expectations.  Yes, there may be an inflation catch up period, but over the long-run the inflation rate would be governed by the inflation rate implied by the price level target.  (Of course, an even better solution would be targeting a NGDP level, but I digress.) Second, for the 100¹⁰⁰ time, inflation expectations are not stable or well anchored.  The have been falling all year across all horizons as can be seen with the Clevend Fed data .  This sustained decline can also be seen below on a daily basis for the five-year horizon:

How can there be any question about falling inflation expectations?  (For those concerned that the liquidity premium is distorting the implied expected inflation rate from the Treasury market note the following.  First, the Cleveland Fed data corrects for this potential distortion.  Second, even in the case of the chart above a heightened liquidity premium only reinforces the likelihood of growing deflationary pressures. This is because a heightened liquidity premium implies a heightened demand for highly liquid assets like treasuries and money. In turn, this implies less spending and greater deflationary pressures.) Third, if there is anything driving increased uncertainty it is a weakening economy. And by failing to stabilize  inflation expectations, the Fed is allowing economic uncertainty to grow.  Bernanke seems hung up on a potential source of economic uncertainty instead of looking to an actual source of economic uncertainty. 

What a big tease.