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Ben Bernanke on Why the Fed Has an Inflation Target of 2%

In making the argument for electronic money, I have argued that the main reason major central banks have an inflation target of 2% rather than zero is because of worries about the Zero Lower Bound. To back that up, here (thanks to Akshay Mishra’s pointer) is a Q&A addressing that issue from the official transcript of Ben Bernanke’s March 20, 2013 press conference, pp. 18-19:

RYAN AVENT. Ryan Avent, The Economist. You’ve noted that most of the committee members don’t expect an increase in rates until 2015 or 2016, and it looks in the projections as though the expectation for the long run rate of the Federal Funds target is around four percent which should below the sort of peak rate we saw before the recession. Given the committee’s concerns about unconventional policy, is there any feeling on the committee that perhaps recovery isn’t going fast enough and that more accommodation would be justified? And has there been any discussion about a change in policy targets to try to stay effective without much of a cushion there between the Fed Funds target rate and the zero lower bound?

CHAIRMAN BERNANKE. Well, as you point out, we’re at the zero lower bound and that makes further accommodation not impossible but more difficult and harder to predict and with more side effects that are difficult to predict. I’m not sure I understand the whole thrust of your question. We have—as, you know, we have given this guideline for—so we call them signposts for how the funds rate is going to evolve over time. And as a lot of academic research shows, you know, when you’re close to the zero lower bound, by telling markets that you’re going to keep rates low for a significant period, that’s one way to get longer term rates down and to provide more stimulus to the economy. And we think this has been a pretty effective tool. Now, we could go further. We could lower even further say the unemployment that rate number that we hit. We’ve discussed variants and at least one member of the committee has suggested that. But for right now, we find that the thresholds that we have put into that rate guidance seemed to be sufficient to approximate the—what’s called the Optimal Control Path of Interest Rates that it seems to give a path of unemployment inflation that’s about as good we can get with the monetary policy tools that we have. It doesn’t mean we’re satisfied. It just means that we don’t have enough fire power to get the economy back to full employment more quickly. I don’t know if that was responsive or not.

RYAN AVENT. I guess I’m not—given the concerns about unconventional policy relative to normal interest rate policy, is there a feeling that more should be done so that in the next potential recession rolls around, we have more room to cut rates, or are you comfortable just using these threshold policies on an ongoing basis?

CHAIRMAN BERNANKE. I see. So you’re talking about the inflation target, basically. Is that fair?

RYAN AVENT. Yeah. I think so.

CHAIRMAN BERNANKE. Yeah. Okay. So historically, the argument for having inflation greater than zero—we define price stability as 2 percent inflation as do most central banks around the world. And one might ask, “Well, price stability should be zero inflation. Why do you choose 2 percent instead of zero?” And the answer to the question you’re raising which is that if you have zero inflation, you’re very close to the deflation zone and nominal interest rates will be so low that it would be very difficult to respond fully to recessions. And so historical experiences suggested that 2 percent is an appropriate balance between the cost of inflation and the cost that you’re referring to. We haven’t contemplated changing that. We just put that number in as, you know, fairly recently. I think at this point, it’s still being debated in academic circles that—you know, and we’ll see what kind of outcome they come up with. But it’s an interesting question to try to quantify. There is research, for example, which asks the question how often do you tend to hit the zero lower bound? And our belief few years ago was that it was a very rare event and now it has become more common. So I’m sure there’d be a lot of thinking about this in academic and other circles. 

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