Two Cheers for the Bernanke Rule


This analysis was originally going to be titled “Dr. Inflationlove or: How I learned to stop worrying and love The Ben Bernank.” But I decided that was too flippant, even for me — and, ultimately, misleading.

By explicitly linking interest rates to an unemployment target, the Ben Bernanke-led Fed is undertaking an historic change in how the US central bank conducts monetary policy. And perhaps the change will turn out to be a historic mistake. Perhaps the new target, along with continued massive purchases of mortgaged-backed and Treasury bonds, will eventually lead to an unwanted inflationary surge and squander the Fed’s hard-earned, inflation-fighting credibility. Perhaps QEinfinity will end in lots of tears and little additional economic growth.

That is certainly a risk. No guarantees here, folks.

But let’s look at the economy right now and identity what its biggest problems are. GDP growth will likely come in around 2% for the year, roughly the same as in 2011. And even without a fiscal cliff disaster, 2013 looks like another 2% year. Now, those numbers may make America the envy of other advanced economies, but they reflect an economy continuing to run far below its potential, (as seen in the above chart).

At the same time, the labor market remains in a depression. While the official unemployment rate has dropped a percentage point in each of the past two years, now standing at 7.7%, the collapse in labor force participation means that number greatly overstates the improvement — even when taking into account demographic factors. The “real” unemployment rate is more like 10%, and that’s not even including all the part-timers who wish full-time work. And the longer one is unemployed, the tougher it gets to find that next job.

And inflation, the other half of the Fed’s dual mandate? It’s running at under 2%, according to the Fed’s preferred measure. And the Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is a mere 1.53%.

Growth is the problem. And the Fed can be part of the solution. Economist David Beckworth on the Fed’s policy shift:

This is huge. It makes very clear to the public that the Fed will not stop until these targets are hit. Markets, in turn, should respond in anticipation of these goals being hit. That is, the elevated demand for liquid assets should start declining as households and firms start moving their funds into higher yielding assets. This rebalancing should raise asset prices, help repair balance sheets, and ultimately spur nominal spending. In other words, by better managing expectations, the Fed should cause the public to do the heavy lifting–and they already have started. If all goes according to plan, the Fed may not have to actually purchase that many additional assets. Ironically, this means that had the Fed been doing this all along its balance sheet would be much smaller now

Now, it would better if the Fed adopted a clear nominal GDP target – correcting for departures from that goal in either direction – but the Fed’s move to adopt numerical thresholds for low interest rates is another important step forward, hopefully, to that eventual goal. Bernanke would get three cheers there.

Overly tight monetary policy from the Bernanke-Fed in 2008 may well have turned a minor recession from a housing collapse (itself perhaps a product of an overly loose Fed) and oil price spike into the Great Recession. And monetary policy cannot alter long-term structural issues with the US economy for which we desperately need supply-side tax, regulatory, immigration, and education reform.

Still, the Fed can help. Indeed, it probably already has with the previous rounds of quantitative easing, despite being ad hoc, stop-and-go, and poorly communicated. Economist Michael Darda of MKM Partners: “While some have argued that the Fed’s efforts have been futile, we believe they have been exactly enough to keep nominal GDP growing at a steady 4% per annum rate despite a modest fiscal consolidation that will continue into 2013.”

Life is about making tradeoffs and taking risks. The Bernanke Rule is a smart risk to take.

There are 11 comments.

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  1. Profile Photo Member

    This is not going to end well. Inflation is already running at a pretty high level when you look at basic commodities. Oil’s not taking off because sluggish economies are keeping demand down; it’s certainly not because of the value of the dollar, which looks good only in relation to the other world currencies. Without the ability to use interest rates as a tool for stifling inflation, I have every expectation that we’re going to see inflation levels that rival the end of the Carter presidency.

    • #1
  2. Profile Photo Member

    I just spent the day with a 69 year old food entrepreneur selling his food business.

    He manufactures a food product and tells me he stopped selling in the US two years back. The Canadian dollar has risen 50 % in the last five years.

    So this business used to make the bulk of profit from the US sales and was now losing money so he decided to jump up his prices in order to close down his US sales.

    Inflation is already happening big time, your government is doing a good job hiding it from you.

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  3. Profile Photo Member

    Looking at your chart, the slope of the line represents GDP growth, yes?  If so, then 2% is about where we’ve been in the recent past.  It only looks like a gap because we would have to grow faster then “normal” to close the delta.

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  4. Profile Photo Inactive

    Glad to see I’m not the only one worried about this.

    You left out one major component:  debt, specifically its affects on growth.  Households are deleveraging in a major way for the first time on record:


    Ignoring public debt for a moment (a huge thing to ignore, but still): if households continue to deleverage, and inflation continues to rise, the growth targets the Fed set will get harder to achieve.  And if we are in an economy that can only grow through new debt… will Bernanke continue to push for more inflation and more debt, in an endless spiral?

    Add that to the increasing pace of central bank interventions, and you get a picture of a Fed that has less and less faith in the organic, “real” economy.  A cynic might say these new targets are just political cover for continuing to intervene, instead of a thoughtful calculation about inflation and growth tradeoffs…

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  5. Profile Photo Member

    The problems with the US economy are not mainly caused by monetary policy; they are a function of excessive and mis-regulation, hypertrophy of the legal and finance industries, dysfunctional public schools which cripple the future employability and productivity of their students, etc etc. Trying to fix all this with monetary policy is like trying to force more air through a hose that has several heavy people standing on it.

    See my post releasing the brakes and advancing the throttle works better than trying to push the train.

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  6. Profile Photo Inactive

    Helicopter Ben is the most dangerous man in the world.   He suffers the arrogance of intellect.  This ends poorly.  Romney was going to can him yet others in the halls of world power wanted him to stay.  How much of this past election may have related to this issue?

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  7. Profile Photo Inactive

    I’m thoroughly enjoying that reference to “The Ben Bernank” from that really well done QE video that was posted on ExtraNormal several months back.

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  8. Profile Photo Coolidge

    I think the Fed has too much wrong on its own hands to even try to link two things that can be largely uncorrelated.  Low interest rates do not create employment, although on the surface it might seem that cheap money would create investments that require labor.  Low interest rates simply mean the Fed has a low-interest rate policy – what companies do with cheap money is nothing, everything, something else entirely.  Just because  money is cheap doesn’t mean I would want to spend it, and if I did, think about those decisions in aggregate, in terms of what it might be spent on (capital investments, real estate, markets, etc), and you’ll have a muddle as a result, with no clear conclusions drawn.

    People are hired based on expectations.  Expectations of the present or future demand for labor.  If expectations are iffy, there’s less hiring, there’s less investment in new buildings, tooling, IT infrastructure, you name it.  As long as expectations are low (and they are), you won’t see hiring or job growth – no matter how low the rates go.  And that’s what’s been happening, so what has changed?

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  9. Profile Photo Inactive

    Can someone please explain to me what money the Fed uses (and where it comes from) to buy US government debt?

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  10. Profile Photo Coolidge
    david foster: See my post releasing the brakes and advancing the throttle works better than trying to push the train. · 2 hours ago

    Well, Millman has a lot wrong, doesn’t he?

    Energy independence…..would mean higher energy prices (if it was economically efficient for us to be independent, we would be). But what Romney really means is simply to roll back regulation against drilling and mining. More energy development will indeed create some jobs–it’s doing so in Western Pennsylvania, in North Dakota, for example. But it won’t make a big dent in a 12 million job goal.

    At least he acknowledges that some jobs will be created. Millmyn seems to miss, entirely, the other aspect of energy: cost. It costs money, in energy, to build things. To turn the lights on. When those costs go down (as they would, despite his statement that energy prices would go up, since production would be domestic, and BTUs are cheaper per unit in natural gas), that means the price of almost everything will go down,or increase at a slower rate.  Lower prices=greater demand=new jobs to fill the greater demand.

    See how easy that was?

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  11. Profile Photo Member
    Koblog: Can someone please explain to me what money the Fed uses (and where it comes from) to buy US government debt? · 1 hour ago

    The Fed is issuing debt and then printing the money to buy it back.

    • #11

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