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.