Depending on whom you ask, Ben Bernanke?s speech at Jackson Hole is either a signal that he?ll do nothing in the face of a weakening economy, or a welcome indication that he intends to rally the Fed behind more stimulative measures. We?ll find out who?s right after the Federal Open Market Committee (FOMC) meets next month, but until then it?s worth asking what the Fed can actually do.
There is no shortage of policy moves the Fed could take now. It could lower the interest rate on reserves, initiate another round of quantitative easing or change the composition of its debt holdings. But many economists think the most important thing it could do is signal it will allow higher inflation in the medium term. Higher inflation would eat away at household debt, allowing consumers to spend rather than pay off loans. This increases demand, and thus growth and employment. As Justin Wolfers notes, this could take a number of forms. The Fed could, as Kenneth Rogoff and IMF chief economist Olivier Blanchard have suggested, state openly that it is targeting a higher rate of inflation ? say, 4 percent instead of the current 2 percent target. It could, as Greg Mankiw has proposed, change from a 2 percent inflation target to a 2 percent price level target, which would allow higher near-term inflation. It could even, following Scott Sumner, start targeting nominal GDP, which would allow more inflation (because the target is nominal, not real) and also make Fed policy directly focused on ensuring higher growth. It could even just say it wants higher short-term inflation, as Michael Woodford suggested this morning, without adopting big changes to its targeting approach.
The key to all these proposals is that the Fed?s statements and actions can affect inflation expectations, and thus inflation. By spurring a bit more inflation, it can then drive up growth and speed the recovery along. But though the people proposing this know whereof they speak ? Woodford is arguably the most respected monetary theorist alive today ? there are a number of economists who dispute the idea that the Fed, at the moment, can do much to drive up inflation. Peter Diamond, the Nobel laureate and failed Fed nominee, told Ryan Avent in an interview that although the Fed can set a level of inflation that it?s willing to tolerate, it can?t itself spur inflation. Donald Kohn, who served as vice chairman of the Fed from 2006 to 2010, told me he also doubts the Fed can do much to spur inflation at the moment. The Fed can create inflation, he explained, either by spurring demand so high that there?s upward pressure on prices (obviously, not a problem right now) or by creating credible inflation expectations. ?At this point with the economy operating so far below potential and monetary policy having trouble pushing it higher one might wonder whether either of these would be operative right now,? he said in an e-mail. With demand as low as it is now, convincing the markets that inflation is going up might be impossible, so it could be that the Fed just can?t affect inflation expectations for now.
And then there?s the question of whether higher short-term inflation would spur growth and employment, even if the Fed can produce it. Mark Zandi, chief economist at Moody?s Analytics, doubts it. He thinks another round of quantitative easing might do some good, and doesn?t doubt that the Fed can increase inflation if it wants to, but argues that driving up inflation expectations would increase interest rates and could cause inflation to spiral out of control. ?I don?t think the Fed can inflate our way out of our economic problems,? he said. ?It?s a very risky sort of game to play. If it does truly affect inflation expectations, that?s a very difficult thing to reign in.? Joel Prakken, chairman of Macroeconomics Advisers, suggests that trying to spur growth by increasing inflation expectations gets what?s causing what reversed. ?Inflation expectations are not certain to move up if current inflation remains subdued because of the weak economy...the Fed might not be able to stimulate the economy enough to convince people inflation is headed higher any time soon no matter what,? he said.
Obviously, it would be great if the Fed had the power to spur growth through higher inflation, and there are a lot of economists who think it does. But it?s not a settled matter by any means.
Source: http://feeds.washingtonpost.com/click.phdo?i=f014055b7b103bdb06ebdb4a54bc2a12
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