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Bernanke Used to Know What to Do

By Matthew Yglesias on December 7, 2009 at 9:58 am

"Bernanke Used to Know What to Do"


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Even though Ben Bernanke is a conservative Republican Bush appointee, and even though the Fed mishandled a lot of things before the Bear Stears meltdown and Lehman Brothers bankruptcy, a lot of people I know were reasonably glad he was Fed chair as the country headed into major economic crisis. Why? Well largely because his pre-government academic work really seemed to indicate that he appreciated the need for drastic anti-crisis measures. Scott Sumner, for example, links to this 2003 paper in which Bernanke has very reasonable ideas for what a country in our kind of situation ought to do:

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap (Bernanke, 2000). The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place. [...]

A concern that one might have about price-level targeting, as opposed to more conventional inflation targeting, is that it requires a short-term inflation rate that is higher than the long-term inflation objective. Is there not some danger of inflation overshooting, so that a deflation problem is replaced with an inflation problem? No doubt this concern has some basis, and ultimately one has to make a judgment. However, on the other side of the scale, I would put the following points: first, the benefits to the real economy of a more rapid restoration of the pre-deflation price level and second, the fact that the publicly announced price-level targets would help the Bank of Japan manage public expectations and to draw the distinction between a one-time price-level correction and the BOJ’s longer-run inflation objective. If this distinction can be made, the effect of the reflation program on inflation expectations and long-term nominal interest rates should be smaller than if all reflation is interpreted as a permanent increase in inflation.

And yet here in the contemporary United States when Bernanke has the chance to put these ideas in practice, he’s not doing it. But we’ve been having below-target inflation for a while now. And we’ve got 10 percent unemployment. And our forecasts tell us that elevate unemployment will continue for a loooong time. The appropriate solution, as Bernanke laid out here, is for the central bank to continue monetary expansion until the price level “catches up” with where we’d be on a reasonable growth trend. That means a limited period of time in which inflation exceeds the standard target by a limited amount. But instead of doing this, the Fed remains obsessed with trying to eliminate all risk of inflation rising above the long-run target for even a moment. But why?

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