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While being questioned in his Semi-Annual Report to Congress, Federal Reserve Chairman Ben Bernanke was criticized as dovish for his expansion of the Fed’s balance sheet. In response, Bernanke retorted, “You called me a dove … My inflation record is the best of any of the governors in the post-war period.”
The Bernanke Fed has interpreted its mandate for price stability as a call for a 2 percent inflation target. Fearing deflation, the tolerable lower bound for inflation at the Bernanke Fed has been about 0.6 percent, as the Fed initiated a $600 billion program in 2010 to combat deflation after the core consumer price index dropped to this low. In the name of spurring employment growth, the Bernanke Fed is willing to tolerate inflation as high as 2.5 percent, a position articulated in the FOMC’s December 2012 policy statement.
By and large, Bernanke has been successful in staying within these parameters. Headline inflation has averaged 2.3 percent since Bernanke took over, the second lowest average of any of the post-war Fed chairmen. But the Bernanke Fed is not as successful as its chairman thinks in correcting the inflation errors of the past.
Toward Zero Percent Inflation
Price stability has not always implied 2 percent annual inflation to the Fed’s board. In the 1950s and early 1960s, the goal of the Fed was literally price stability — zero percent inflation. By this measure, the most successful Fed chairman is William McChesney Martin. From 1951 to 1970, Martin kept inflation around 2.2 percent, with periods of slightly higher or slightly lower inflation throughout. Martin inherited Korean War inflation near 10 percent, and he pursued disinflation until deflation took hold of the economy. Notably, real GDP growth during the period of Martin’s deflation averaged 2.8 percent. This number, in line with historical trends in US expansion, questions the conventional wisdom about the problems associated with deflation.
The post-Martin era from the late 1960s to the mid-1980s came to be known as the “Great Inflation” because the Fed failed to keep inflation in check. Fed Chairmen Arthur F. Burns and G. William Miller presided over average annual inflation rates of 6.5 percent and 9.0 percent respectively. This period of high inflation was a remarkable failure of monetary policy that resulted in the bankruptcy of the thrift industry, heavy taxation of the US capital stock, arbitrary redistribution of wealth, and the destruction of the Bretton Woods system of fixed exchange rates.
Throughout the 1970s, Fed minutes show debates about interest rates over the coming month or two, with virtually no discussion about the longer run implications of their decisions. The most striking statement comes in the February 1972 minutes, where one FOMC member says, “It had not been demonstrated that total or nonborrowed reserves had any strong or direct effects on the ultimate goals of the economy.” As Federal Reserve historian Allan Meltzer has pointed out, this statement shows the Fed saw no clear link between money and prices or economic activity. This is a strange position for a central banker to hold, and one of the principal reasons the Fed was unable to contain inflation during this time.
Variability Leads to Moderation
The shift to Fed Chairman Paul Volcker in the late 1970s eventually brought about the end of the Great Inflation. Volcker felt the inflation forecasts of the Fed staff were inaccurate and unreliable, and he opted largely to ignore the unemployment portion of the Fed’s mandate to pursue price stability. The decline in inflation from 14.8 percent to 1.1 percent under Volcker came at a high price when interest rates soared, but it convinced markets that inflation would remain low and stable over time.
Volcker is by far the most credible chairman in terms of fighting for a drop in inflation, but steadiness was not his forte. Inflation varied more widely under Volcker than under any other Fed chairman in the post-war period. His successor, Alan Greenspan, presided over the most stable inflation in the post-war period in a time that has come to be known as the “Great Moderation.”
Inflation and growth both averaged 3 percent during the Greenspan years. In general, politicians wished for 1 percent lower inflation and 1 percent higher growth during this period, but Greenspan’s record at holding inflation in check is clear, as the standard deviation of inflation during Greenspan’s tenure is barely over 1 percent.
Bernanke’s Inconvenient Facts
The trouble with Bernanke’s claim to the Senate committee is that it ignores inconvenient aspects of his tenure. During his time at the Fed, energy and food prices have been highly unstable, global exchange rate fluctuations have led to historically high volatility in the US trade balance, and the largest global financial crisis since the Great Depression produced a tripling of the Fed’s balance sheet and deflation scares.
The short-term focus of the Fed in the 1970s has been replaced with more emphasis on the medium term, but the Bernanke Fed has been prone to the same myopic mistakes that plagued Burns and Miller. Rather than combating deflation and supporting markets in 2006 and 2007, the Fed acted reactively after disinflation and crisis were well underway. Presently, with a massive balance sheet, the Fed has yet to articulate an exit strategy that could be undertaken without enormous costs to the American economy.
The Market Is Worried
The news over the past two weeks that the Fed might start to unwind its balance sheet, absorb losses on assets, and/or pay out tens of billions per year in interest payments on bank reserves spooked markets. Indications are that firms are nervous about the Fed’s outlook. If markets become convinced the Fed’s balance sheet has grown unwieldy — or if inflation expectations become unanchored — the Bernanke legacy will be a long and costly process of tightening monetary policy to reanchor inflation expectations and restore confidence in the Fed.
Bernanke is correct to be defensive about his record on inflation, but he should be more concerned about the longer run implications of his policies. With only a marginally better inflation record than his predecessors and a highly uncertain future path for monetary policy, the Bernanke Fed must learn to be vigilant and proactive.
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