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US Monetary Policy at a Crossroads: Ben Bernanke Has a Decision to Make

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Or is Bernanke trying to send the market a message that he is indeed targeting nominal GDP without admitting it?

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Last week I went on a business road trip with my boss to attend regional board meetings at a couple of our branches up and down the Mississippi River Delta. As we departed Memphis, I asked if instead of the interstate we could take the infamous Highway 61 south through blues country. This is perhaps the most impoverished area of the country and was a very eye-opening experience that provided some economic perspective. In the Delta, they don't care about quantitative easing or the dual mandate of maximum employment in the context of price stability.

This week Chairman Ben Bernanke will deliver his semi-annual Humphrey Hawkins testimony to Congress. The Humphrey Hawkins bill passed in 1978 gave the Federal Reserve its dual mandate, and ever since the Fed has been tinkering with monetary policy to achieve this objective. No doubt when Bernanke speaks he will provide his standard assessment that the economy continues to grow at a moderate pace. What he will not provide is an explanation for why, after three years of extraordinarily easy monetary policy and improving employment metrics, the second quarter growth rate is on pace to print the lowest GDP of the recovery.

Due to their mandate, monetary policy measures success by virtue of the unemployment rate, but policy implementation is focused on stimulating aggregate demand, which in turn stimulates economic activity, which fosters improved employment. During this cycle, though, improved employment has not been a function of increased aggregate demand. The Q2 year-over-year growth rate in PCE is trending at an average of 2.65% near the lowest in 50 years down from 3.1% in Q1 and 3.5% in Q4.

PCE Vs. PCE Deflator



Since 2010 the YoY growth rate in wages has been trending at 1.9% per month and in June grew at its fastest pace of the year at 2.2%. However, what's unique about this stage of the cycle is that wage growth is not translating into consumption growth. For example, in 2011, the last time wages grew at 2.2%, consumption was growing at over 5.0%. This speaks to the economic uncertainty, quality of jobs, and is why, despite an improved employment picture, the growth rate of the overall economy remains tepid. This distinction exposes the shortfall of quantitative easing and the power of the deleveraging cycle.

When Chairman Bernanke delivered his speech to the NBER on Wednesday the market seemed to focus on his comments made during the Q&A about the inflation being too far below the Fed's target. I thought the most interesting comment was made in text of his speech when he credited Princeton economist and noted inflation target advocate Lars Svensson:

The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following ideas of Lars Svensson and others, the FOMC has moved towards a framework that ties policy setting more directly to the economic outlook, a so-called forecast-based approach.

The footnote to that sentence cites Svensson (2003).

In 2003 Svensson wrote a working paper for the NBER titled Escaping From a Liquidity Trap and Deflation: The Foolproof Way and Others (emphasis mine):

Given that the central bank cannot reduce the nominal interest rate below zero, what is the best way to escape from the recession and deflation?

The real interest rate is the difference between the nominal interest rate and expected inflation. Thus, even if the nominal interest rate is constant at zero, the central bank can affect the real interest rate, if it can affect private-sector inflation expectations. If the central bank could manipulate private-sector beliefs, it would make the private sector believe in the future inflation, the real interest rate would fall, and the economy would soon emerge from recession and deflation.

Svensson's solution to managing this "rational-expectation" is for the central bank to announce a positive inflation target or a price-level target path:

Several authors have proposed the announcement of a sufficient positive inflation target as a commitment to a higher future inflation rate (for instance, Bernanke (2000); Krugman (1998); Posen (1998)). In line with the optimal policy of a future overshooting of the normal inflation target, this target should be higher than normal for a few years. Krugman (1998) has stated that the central bank should "credibly promise to be irresponsible," by which he means setting an inflation target higher than might otherwise be desirable.

Another possibility is to announce an upward-sloping target path for the price level, perhaps rising at 1-2 percent per year, as suggested for Japan in Svensson (2001) and more recently Bernanke (2003). The practical difference between these two approaches is that if inflation falls short of the inflation target in one year, the inflation target for the next year does not change.

However, with a priced level target, lower inflation in one year must be counter balanced by a higher rate of inflation in future years to return to the desired price level path. In the context of escaping from a liquidity trap, a price-level target offers an advantage above an inflation target, since long-term inflation matters more than short term. Long real interest rates are long nominal rates less long term inflation expectations.

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