Fed up with the full empoyment target?

The debate on Bernanke's views on inflation targeting -- whether it should be 2 or 4% -- as I noted in a previous post is peculiar, to say the least. After all the Fed has a dual mandate, and inflation preoccupations have to be tempered by the pressing question of unemployment. The preoccupation in some quarters is that the Fed has already accepted as a matter of fact that it has single mandate (see here and here). It seems to me that critics (e.g. Krugman, DeLong and others) are correct for the wrong reasons.

The graph below shows the effective Fed Funds rate in the last three recessions (represented by the shaded areas). The rate of interest falls in all three during or just before the recession.

Further, after the trough of the recession the Greenspan Fed took 46 and 35 months to start raising the rate in the previous two recessions. So far, 35 months after the last trough, the Bernanke Fed has not increased the rate. This time around it has done Quantitative Easing allowing for lower long term rates too, which was not done during the Greenspan era. If anything the Fed has done more now than under Greenspan, and unless you believe in the inflation expectations fairy, the old Eccles maxim is still true, monetary policy now is like pushing on a string.

So how is that critics of the Fed are correct and I believe that the dual mandate (full employment and inflation) is gone. Well look at the graph below. It shows the Fed Funds, again, with the 10 year Treasury bonds rate.

Notice that the Fed eventually raises the Fed Funds sufficiently to surpass the bond rate, and invert the yield curve. The point is to slowdown the economy, and avoid full employment. Even in the 1990s, when Greenspan allowed the bubble to continue and unemployment to fall below the then official limit of 6%, he eventually took action, when wages started to increase. Full employment has not been a target, but keeping workers demands for higher wages checked has been very much part of the reaction function. Jamie Galbraith has written about it (go here for a technical paper). So the Fed has a single target mandate, but is not an inflation target, it is a "fear of full employment target."

The Fed can do practical things like helping distressed borrowers (with defaulted or underwater mortgages), but it cannot directly increase spending, and in the absence of private spenders (domestic or foreign), or local governments, it must be the federal government. Bernanke is not the problem right now. Geithner is (and so is Congress).

PS: The New Keynesian view that if you increase expected inflation spending goes up is now defended by Brad DeLong. He says: "an extra $100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery." I'm not against QE per se, the idea of maintaining long term rates low. But the notion that it would lead to inflation (printing money generates inflation) and that expected inflation generates a boost in productive spending is clearly another confidence fairy story.

The inflation expectations fairy

There are confidence fairies and there is the inflation expectations fairy. It's a 4% fairy apparently. I'll explain. So Krugman correctly points out always that the more fundamentalist neoclassical economists (the Talibans that love price flexibility and instantaneous adjustment to full employment, not the moderates that also believe in a natural rate, but think it takes a while to get to it like Krugman himself) believe that the economy would recover if only a proper environment for investment was created. Hence, if confidence returned we would have a recovery.

They obviously invert causality between confidence and recovery. As noted by Marriner Eccles long ago: "confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time." Investment is the result of a growing economy, in which firms tend to adjust their capacity to demand. No demand for your goods no need to invest to create capacity to produce more. Plain and simple.

Now a dispute on what is the appropriate policy for the Fed, and what has been Bernanke's role has developed between Krugman and Bernanke (see here and here) [Ball has a more academic paper saying basically the same as Krugman here]. They argue that Bernanke has been correct in pursuing quantitative easing -- the buying of long term Treasury bonds to keep not just short, but also long term interest low -- and saving banks, but he has been reluctant to increase the inflation target to 4%. Blanchard has said pretty much the same about the need for a higher inflation target (this was hailed as new thinking in macroeconomics; with that criteria when Greenspan disregarded the 6% natural rate of unemployment level, believing it was somewhat lower, he was a radical innovator!). [I’ll leave for another post the question of why are we even talking about an inflation target in the US if the Fed supposedly doesn’t have one].

Krugman notes that Greg Mankiw actually has sent a veiled (or not so veiled threat, as he is the advisor to Romney, which may or may not have something to do with Bernanke’s reappointment in the future), saying that “if Chairman Bernanke ever suggested increasing inflation to, say, 4 percent, he would quickly return to being Professor Bernanke” (originally published here, yep Mankiw also writes regularly for the NYTimes).

So what is the mechanism according to Krugman (and the ‘progressives’ like the IMF chief economist Blanchard) by which a higher inflation target would lead to a recovery. In Krugman’s own words:

"If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher. … [and] higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea. "

So if the Fed says it’s willing to accept a higher level of inflation – without doing anything concrete and objective like intervening and forcing banks to refinance the mortgages of people in foreclosure – then if investors are persuaded they may be confident enough to spend more. And that’s not a fairy?! The problem with any theory, including the New Keynesian, that believes [or says it does in order to get published] that there is a tendency to full employment, is that it must end on some sort of confidence for spending story, since under normal conditions the system would actually do it anyways. The confidence fairy is dead; long live the inflation expectations fairy!

Zingales vs. DeLong: Eccles wins!

So Luigi Zingales, from the University of Chicago, said that "the current crisis is not a demand crisis, it is a trust crisis," as quoted in Brad DeLong's post. DeLong replies that "bad government policies certainly produced a trust crisis," and "as a consequence, all across the economy agents cut back on their expenditures on currently-produced goods and services." In other words, this is a confidence crisis that led to a demand crisis.

Marriner S. Eccles, the chairman of the Fed during the depression, wrote in his autobiographic book, Beckoning Frontiers, that "confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time." Put clearly, lack of trust is the result of lack of demand. I suppose, in Chicago and Berkeley, Eccles, and common sense, are démodé.