What is the State Line Regional Economic Report?
In this second issue of the Stateline Regional Economic Report, we have a special feature by Professor Stuart Glosser of the Economics Department of the University of Wisconsin-Whitewater regarding the nomination of Ben Bernanke as the Chair of the Federal Reserve System. This appointment will ultimately affect our region in regards to issues such as employment, interest rates, and inflation.
The goal of the Stateline Regional Economic Quarterly is to highlight the important economic trends that impact the regional economy and the competitiveness of local industries. This is an extension of the Fiscal & Economic Research Center at the University of Wisconsin-Whitewater. Each issue will include the latest data on regional employment and economic conditions. Feature articles will cover a variety of economic and demographic issues at both the county and municipal level. Once you have an opportunity to review the initial issue, we would appreciate your feedback on how useful it is to you and what topics you think should be included in future issues. The editors of the State Line Regional Economic Quarterly can be reached at heinricj@uww.edu or kashianr@uww.edu
Ben Bernanke and the Federal Reserve Bank
By: Stuart Glosser, PhD
On October 24, 2005, President Bush nominated Ben Bernanke to become the chair of the Federal Reserve System. Currently Bernanke is the chair of the Council of Economic Advisers, a post he has held since June 21st of this year. Before this, Bernanke served on the Federal Reserve’s Board of Governors from 2002 through 2005 and before that, he was Chair of the Economics Department at Princeton University.
Ben Bernanke is a strong proponent of “inflation targeting.” The purpose this article is to explain inflation targeting.
The inflationary episode that occurred between the mid 1960s through the late 1970s made clear that low inflation is an important priority. High inflation, as well as uncertainty about the expected course of inflation destabilizes the economy. A central bank that fails to convince the public that it is both capable and willing to stabilize inflation loses credibility, further contributing to destabilization. Once lost, the cost of regaining credibility is high. It took two back-to-back recessions between 1980 and 1982 for the Fed to rein in inflation. And even then, it wasn’t until mid-1984 before the bond market began to believe that the Fed was serious about keeping inflation low.
Inflation targeting is the answer to a debate that began during the inflationary experience: At issue was whether monetary policy was best delivered by following a rules based approach on the one hand, or a discretionary approach on the other hand. The generally accepted belief is that monetary policy is neutral in the long run -- there is no long-run tradeoff between output (or unemployment) and inflation. The rules versus discretion debate therefore pertains to whether policy makers are capable of conducting monetary policy without initiating actions leading to higher future inflation.
Those favoring the rules approach answer an emphatic no. Monetary policy makers, left to themselves, are likely to engage in policies (perhaps to help an incumbent politician gain reelection) that lead to higher inflation. Advocate of the rules approach argue that the inflationary episode of the 1960s and 70s were, in part, a result of such lack of discipline. The remedy would be a policy such as the constant money growth rule advocated by Milton Friedman. Such a rule requires that the money supply grow at a fixed predetermined annual rate regardless of the prevailing economic or financial conditions. Under this rule, central bankers have no discretionary power. The benefit of this rule is that the central bank gains and maintains credibility for keeping inflation low.
Those favoring the discretionary approach argue that the economy is always subject to shocks of various sorts: demand shocks (perhaps because of hurricanes); supply shocks (perhaps caused by a sharp rise in energy prices); or even structural change (such as recent improvements in productivity). Under the rules approach, the economy could be subjected to large, destabilizing fluctuations because policy makers have no power to deal with these changing conditions.
Inflation targeting resolves the rules/discretion debate by leaving room for short-run discretion, but requires policy makers to recognize possible inflationary consequences. In addition, policy makers would be required to communicate with the public about possible inflationary effects. In an article coauthored with Frederic Mishkin, Bernanke describes inflation targeting as a “framework for monetary policy, within which ‘constrained discretion’ can be exercised.” This is to say that the Fed is free to respond to changing economic conditions in the manner it deems best, as long as that response does not prevent the Fed from achieving its inflation target.
In the above-mentioned article, Bernanke and Mishkin use the analogy of an anchor to describe inflation targeting. Inflation targets behave like an anchor by keeping the economic ship in the desired area while at the same time permitting the ship to maneuver in response to unpredictable swells and currents in the economy.
Many economists believe that current monetary policy as orchestrated by Alan Greenspan can be classified as inflation targeting with an implicit inflation target in the range of 1 to 2 percent (as measured by core personal consumption expenditures). In explaining why this inflation target needs to be made explicit, the economist Marvin Goodfriend used the following analogy: “[t]he priority for low inflation is ‘in the water’ at the Fed these days, but on the other hand ‘bottling’ it for the future may not be a bad idea.”
In sum, Bernanke’s inflation targeting policies mean the Fed would set forth the explicit inflation goals it intends to achieve and maintain, and so would communicate to the public that it considers low and stable inflation to be a major goal of monetary policy. Such a policy also means the public would know that the Fed has a commitment to which the public can hold the Fed accountable. Because many economists believe that Alan Greenspan’s policies amount to implicit inflation targeting, Bernanke’s explicit inflation targeting policies do not really represent a new direction for the Fed: few changes from the current policies are to be expected.