Although Ben Bernanke has pledged to ensure a continuity between the Greenspan policies and his own, he differs in several important respects, including his endorsement of “inflation targeting.” Greenspan has always been against it.
But Bernanke’s idea of “inflation targeting” is in need of some deconstruction.
First and foremost, it means that he actually wants some positive rate of inflation, a rate that is expected to persist and therefore gets factored into nominal interest rates. He wants nominal rates kept high enough to give the Fed some elbow room. That is, if the nominal fed-funds rate is, say, 5%, then the Fed has some scope for lowering that rate — in the event that it believes the economy is due for a monetary infusion.
Bernanke was most vocal about this view a year or so ago, when the fed-funds rate was 1% and Fed watchers began to worry about Greenspan “having no more arrows in his quiver.” (That was the metaphor of the day.)
Bernanke believes that it is critical that the Fed always has the monetary-infusion option because he considers it essential to avoid deflation at all costs. This judgment derives from the so-called debt-deflation theory of the Great Depression, a theory that was first articulated by Irving Fisher and more recently has been popularized by Bernanke himself in his Essays on the Great Depression (Princeton University Press, 2000).
The debt-deflation theory is no more than the recognition that if an economy suffers a dramatic decline in prices and wages at a time when debt levels are high, the resulting increase in real indebtedness can be debilitating. (This was actually Irving Fisher’s own circumstance: He had borrowed lots of money from his sister-in-law and lost it in the stock market crash.)
What Bernanke has in mind is a little two-by-two payoff table. The cells are labeled “Probability of Inflation”; “Costs of Inflation” and “Probability of Deflation”; “Costs of Deflation.” His policy strategy is driven by what he perceives as a very high cost of deflation. Further, though inflation may have some costs of its own, it also has the benefit of giving the Fed some elbow room, as explained above. This whole framework, of course, translates into a strong bias toward inflation.
But can Bernanke actually pursue a policy of inflation targeting in the literal sense? In other words, can he increase the money supply whenever, say, the CPI begins to indicate an inflation rate below the target rate and decrease the money supply whenever the CPI begins to indicate an inflation rate above the target rate? I don’t think so.
The lag between changes in the money supply and corresponding changes in the CPI is somewhere between 18 and 30 months. This is the “long and variable lag” identified long ago by the monetarists. One of the lessons in Monetary Economics 101 is that a viable target must be one that yields timely feedback to the targeter.
Bernanke is an advocate of inflation targeting. We should understand this to mean that Bernanke is a deflation-scared inflationist.
