Wednesday, November 26, 2014

The Federal Reserve in a Time for Doves

CAMBRIDGE – The battle is on to replace current US Federal Reserve Chairman Ben Bernanke. One might expect the Fed chairmanship – arguably the second most powerful official position in the United States, and certainly the world’s most powerful financial position – to be determined by a conclave of central bankers. In fact, the choice is largely at the discretion of the US president. So let us consider two of the leading candidates, Lawrence Summers, a former US treasury secretary, and current Fed Vice Chair Janet Yellen.

Both Summers and Yellen are brilliant scholars with extensive experience in public service. Whereas the mainstream press seems intent on exploring their candidacies as a contest of contrasting personalities, the fact is that both candidates are extremely well qualified. Moreover, both have a reputation for believing that the Fed should not place excessive weight on price stability relative to unemployment. Normally, this dovish bias would be a handicap; nowadays, it is an advantage.

The importance of technical competence in monetary policy has been proved repeatedly by central banks around the world. According to research published in 2003 by the economists Christina Romer and David Romer, the quality of monetary policy depends critically on whether central bankers have a clear and nuanced understanding of policy making and inflation. The 1920’s, 1930’s, and 1970’s are replete with examples of central bankers who did not understand the basics, and whose economies paid the price.

What this means is not just competence in setting interest rates, but also competence in regulatory policy. Some are criticizing Summers’s ardent pursuit of financial deregulation during the 1990’s, when he headed the US Treasury under President Bill Clinton. But these critics overlook his role in helping to fight that decade’s sovereign-debt crises, and his insistence that the US begin issuing inflation-indexed bonds.

In a complex and ever-changing policy setting, it is almost impossible to get every call right, and the important thing is to learn from one’s mistakes. Winston Churchill famously regretted overseeing the United Kingdom’s catastrophic return to the gold standard in 1925, when he was Chancellor of the Exchequer. His performance, needless to say, improved in later years.

As for Yellen, it is true that she was President of the San Francisco Federal Reserve during the last years of the massive US housing bubble – which was particularly acute in her district. But Yellen’s speeches on financial risks showed more foresight than those of most of her peers.

Typically, one looks to the head of the central bank to serve as a bulwark against political pressure to push down interest rates and raise inflation. My own research in 1985 on inflation and central-bank independence showed that, in normal times, one generally wants a central banker who places greater emphasis on price stability relative to unemployment than an ordinary informed citizen might do. Installing a “conservative” central banker helps to keep inflation expectations in check, thereby holding down long-term interest rates and mitigating upward pressure on wages and prices.

For the past 25 years, the mantra of “inflation targeting” (introduced in my 1985 paper) has served as a mechanism for containing inflation expectations by reassuring the public of the central bank’s intentions. But excessive emphasis on low inflation targets can be counterproductive in the aftermath of the worst financial crisis in 75 years.

Rather than worrying about inflation, central bankers should focus on reflating the economy. The real problem is that they have done such a good job convincing the public that inflation is the number-one evil that it is difficult for them to persuade anyone that they are now serious about reflation. That is why appointing a “dove” would not be a bad thing at all.

Yellen has already developed a reputation as a dove within the Fed, with speeches consistently showing strong concern about today’s high unemployment. And, though many on the left regard Summers as suspiciously conservative, that is hardly the case when it comes to inflation. His 1991 paper on monetary policy is widely cited as among the first to make the case for avoiding very low inflation targets, in part to give the central bank more room to lower interest rates. Back then, Summers clearly viewed himself as a monetary-policy dove: “I would support having someone in charge of monetary policy who is more inflation-averse than I.”

But now Summers’s dovishness is not a problem. In the face of downward nominal-wage rigidity, higher inflation would facilitate sectoral adjustment and achieve a small but useful impact on reducing debt burdens.

If normal times call for a conservative central banker who helps to anchor inflation expectations, now is the rare time when we need a more unorthodox central banker who will fight deflation expectations. A central-bank version of the Vatican’s papal conclave would have a hard time deciding whether to send up the fumata bianca for Yellen or for Summers – or perhaps for someone else (another former Fed vice chair, Donald Kohn, now appears to be in the mix) with similar inclinations.

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    1. Commentedjean nutson

      It has become more urgent than never before to establish more independent and free flowing regulatory bodies that will oversee both the operations and interactions of central banks and all other banks across the globe in order to have a more centralized, sanitized and easy monitoring financial and monetary transactions to ensure a much healthy global economy that will thrive on merit and performance.

    2. Commentedstanton braverman

      I am not convenced that anyone who would be the new Chairman has any idea on what to do. We have been living with artificially low interest rates for so long that they have permeated all over the economic structure. At the same time the need for low interest rates is ending and it is time to get back to market driven rates. The last time it was tried by Greenspan it led to the collapse of the banking industry. If it is tried again it could lead to other major issues. One interesting issue would be the debt service on the Federal debt. If rates (either short term or long term) go up they will cause a significant increase in the amount of debt service which the country may not be able to afford. It will also carry with it a decline in the housing market which the only effective employment generator sector of the economy. But if we do not get rates back up to market driven levels then the banking industry that makes its money by borrowing on the short term to lend on the long term will continue to be reluctant to do its job. We are in a mess and we do not know our way out of it.

    3. CommentedG. A. Pakela

      Inflation hurts those in the lower half of the income distribution more than those in the upper half. Lower paid workers do not have the leverage or bargaining power to demand higher wages to cover inflation. Higher inflation will result in a loss of purchasing power for workers whose incomes have already been stagnant for many years. For the poor, the value of government programs is unlikely to keep pace with inflation. You may harken back to the 1970s with nostalgia as the era you grew up in, but the reality in today's hyper competitive global world is much different than back then. Any economist who advocates higher inflation, as if the Fed can control its trajectory, needs to go back and do some research on what it was like for government policymakers in the 1970s who had to deal with simultaneous high inflation and high unemployment. It would be harder on the poor today.

    4. CommentedFrank Aten

      Technical competence by monetary authorities has been abysmal at best. They have continue the same old canard for the last 30 years of relying on more and more debt to gain the false promise of stability. There has been no stability for the citizen whose wages are now back where they were 30 to 40 years ago at least for 40% of wage earners. The complete misunderstanding of debt and how it effects everything in the long run (not the short run elixir the Fed produces) has lead to policies that have now left this country with less ability to produce any real good or service in order to pay the astronomical amount of debt now in place and currently still be accumulated....completely insane policy a third grader could have figured out was incorrect.

    5. CommentedKen Fedio

      Yellen and Summers. Is that all they have in the bullpen? Looks pretty thin to me. The weasels on The Street will know what they're going to be throwing before they even start loosening up as Bernanke goes to the mound in the seventh.

    6. CommentedBradley Lewis

      What suggests a conclave of central bankers would have more sense than a typical U.S. president? The unwillingness of the Eurozone to abandon its disastrous austerity program suggests the cluelessness of some central bank thinking, though events seem to be moving even the IMF's view. Let's hope the next Fed chair also understands that the sequester has hurt us, not helped, and that our current federal debt is not a problem.

    7. CommentedMarc Laventurier

      What deflation expectations? Those in the bag of sleazy, fear-mongering tricks, nestled between communism and terrorism?

    8. Portrait of Pingfan Hong

      CommentedPingfan Hong

      The Fed indeed has the dual mandates of both maintaining stable prices and achieving full employment, but does this mean the fed can really make trade off between inflation and employment? No hard evidence proves a fixed inverse relationship between inflation rate and the unemployment rate, which varies from time to time: in the 1950s and 60s, this relationship seemed to exist, but in the 70s and 80s, this relationship became a verticals line, and now this has become a horizontal line.

      Another challenge is whether the Fed can use monetary policy to stimulate employment effectively.

    9. Commenteddonna jorgo

      well Professor always intresting and correct too.
      A true i read the biography for both to know not waht they have studying but the experiance ..
      L Summer look's have to much
      for my opinion B Bernake was very good .
      PROBLEM is not FED but the BANK'S working (not correct)
      even the change B B AND COME SOME ONE ELLS IF the bank system (structure) doesn't change not renew but regulatore .nothing will change the situation ..
      inflation was problem not now but all the timing this can some smart economologos or group economologs finding cordination value paper with high prices market but with low tax for the business ..
      make one step front and tow back ..we win one so ..this is good ..
      i am not your capacity to say what is good or bad but i try to use my logic mathematice ..
      thank you